Charles Keating had already put on a full-court press to prevent the Bank Board from adopting the rules on capital, growth, and direct investment. We were impressed by his expensive lawyers and economists. We were utterly amazed, however, by his political power. Within a few weeks, Keating was able to get a majority of House members to cosponsor a resolution designed to kill the rule. We had never seen such raw political power. Gray went forward with the rule even though the administration, the House, and the industry opposed it.
We discovered later that one of Keating’s effective lobbying tactics was to have the state commissioners complain to their congressional delegations about any Bank Board rule that reduced state-granted investment powers. Keating made allies of the state commissioners by offering to sue to have the direct-investment rule declared invalid and by providing small gifts to what was then called the National Association of State Savings and Loan Commissioners (NASSLS). NASSLS was a very poor organization, so Keating’s money allowed its members to stay in places that were not dumps and to have a hospitality suite with alcohol. They were very appreciative.
Keating continued to wine and dine the commissioners despite the failure in late 1984 of the House resolution to stop reregulation. His efforts were so successful that NASSLS was on the verge of voting in 1987, with only one dissent (Bill Crawford, Taggart’s successor), to file a “friend of the court” brief supporting Keating’s lawsuit against the direct-investment rule. Fortunately, just before NASSLS authorized filing the brief, Keating told the press, “There’s no regulator alive who knows what he’s doing” (Kammer 1987). Crawford told his counterparts about Keating’s statements, which killed the brief.
Keating was new to the S&L industry, but he already had a bad track record. An SEC investigation found that he and his mentor, Carl Lindner, had engaged in fraud and insider abuse at Provident Bank. Keating and Lindner signed consent decrees in which they admitted no guilt, but also promised not to do it again (U.S. House Banking Committee 1989, 4:289). The taint led the Reagan administration not to go forward with its plan to make Keating (a major Republican contributor) U.S. ambassador to the Bahamas (U.S. Senate Committee 1990–1991a, 4:101). It obviously should have led to at least the presumption that Keating was unfit to run an S&L, but the agency’s “change of control” tests were a farce in 1984.1
The second reason to fear Keating’s entry into the industry was that he was paying a premium price to the existing shareholders to acquire an S&L that was insolvent by $100 million on a market-value basis. He knew that it was market-value insolvent because of the mark-to-market. A great deal of Lincoln Savings’ reported income in the first two years arose from selling the mortgages he acquired from Lincoln Savings at a loss but accounting for them as a gain.
Nobody asked the question a white-collar criminologist would have asked: Why would any honest buyer agree to pay a substantial amount of money (over $50 million) to the shareholders of an S&L that was insolvent on a market-value basis by over $100 million, when the acquirer was not an S&L and would experience no possible (honest) synergies by acquiring Lincoln Savings’ branch structure? Overpaying makes no sense for an honest buyer. It makes sense for control frauds because they manufacture fictitious profits, and the key determinant of their profits is how quickly they get control of the S&L and cause it to grow massively.
Norm Raiden, before becoming Gray’s general counsel, represented Lincoln Savings in its sale to Keating. He was amazed when Keating wanted the complex deal done so quickly that he was willing to accept contract terms that Norm drafted to be totally one-sided in favor of the seller. Norm anticipated that this would lead to negotiations and compromise language, but Keating simply signed.
In 1993, when I served as the NCFIRRE’s deputy staff director, one of the members of the commission told me that Keating called him immediately after buying Lincoln Savings to offer him the job of CEO. Keating told him having a California charter was “a license to steal” and guaranteed his salary would exceed $1 million. He declined Keating’s offer.
The third reason to fear Keating was that not a penny of his purchase of Lincoln Savings came from his pocket. Michael Milken and the junk bond operations he controlled at Drexel Burnham Lambert provided all the cash for the deal. Milken had a standard operating procedure in such cases. Drexel greatly overfunded the buyer. Keating needed $51 million to purchase Lincoln Savings, but Drexel issued over $125 million in junk bonds out of American Continental Corp. (ACC), the holding company that Keating used to acquire Lincoln Savings. ACC was a failing real estate development company even before it had this crushing debt dumped on it (Binstein and Bowden 1993, 164; U.S. House Banking Committee 1989, 2:370; Black 1985). Milken wanted companies like ACC to be in desperate circumstances; that maximized his leverage over Keating.2
The fourth warning that Keating would be trouble was that he was a major contributor to the Republican Party and was “known for buying politicians.”3
The agency was eventually mesmerized by Keating’s political power, but we did not have the luxury of concentrating on him. He was one of hundreds of high fliers. The agency felt overwhelmed by what had become a deluge of increasingly shrill warnings from the field that things were wholly out of control, particularly in Texas.
In the case of Charles Keating, we have the unusual advantage of having found a planning document. (The full document is reproduced as Appendix A.) It is an August 28, 1985, letter from Michael R. (“Mickey”) Gardner to Charles Keating. The context of the letter is important. Gardner was a lawyer in the Washington, D.C., office of Akin, Gump, Strauss, Hauer & Feld. Akin, Gump (as the firm is called) began in Texas and is one of the premiere lobbying firms in the United States. The firm was predominately Democratic, but Mickey was a senior Republican lobbyist. Robert (Bob) Strauss was the most famous partner, the grand old man of the Democratic Party and its former national chairman. Gardner’s expertise was communications law (which largely means knowing your way around the Federal Communications Commission, the FCC).
One of the great advantages that white-collar criminals have over blue-collar criminals is the ability to use top lawyers, not only at trial but also before criminal investigations even begin. Control frauds maximize this advantage by paying for the lawyers who help the controlling insider loot the firm. Then, as evidence of their legitimacy, control frauds trumpet that they sought legal counsel and that the counsel advised them that their activities were lawful.
One of Keating’s first big plays after acquiring Lincoln Savings was to “greenmail” Gulf Broadcasting.4
Gardner had at least one, and reportedly two, roles in all this. He contended that Lincoln Savings put him on retainer to run Gulf Broadcasting if Lincoln Savings were to buy a controlling interest in it. Lincoln Savings paid $900,000 to Gardner in connection with Gulf Broadcasting. Lincoln Savings did not pay this fee to Akin, Gump, but to Gardner directly at his home address. Since the fee was so substantial and since members of a firm are required to send all fees for legal services to the firm for distribution, Akin, Gump induced Gardner to resign from the firm when the government discovered the payments years later.
Gardner’s claim that this large fee was a retainer to secure his services as CEO is improbable. He had no expertise as a CEO. He did not have to give up any opportunity to make money to be available to act as CEO should Keating gain control of Gulf Broadcasting. The other potential role Gardner had was as a source of inside information, since Akin, Gump represented Gulf Broadcasting. Such inside information would be worth millions to a greenmailer.
By August 1985, Keating knew that he had to neutralize Gray or risk having Lincoln Savings taken over by the Bank Board. Gray had just pushed through the first three of what would become the four pillars of reregulation. Gray restricted direct investments, limited growth, and increased real capital requirements. Gray was pushing the fourth pillar, the power to “classify” assets. Gray was also implementing his two great efforts to improve supervision. He was transferring the examination function to the FHLBs, which were not subject to OMB and Office of Personnel Management (OPM) limits on staff and pay, and recruiting tougher supervisors for key positions.
Gardner was one of several outside professionals whom Keating used to help plan his war against Gray and the Bank Board. Other professionals were usually clever enough to give their advice orally, but Gardner was more brazen. His August 28, 1985, letter to Keating begins by recounting the original strategy that Gardner and Keating developed: have the Reagan administration “dismiss” Gray and replace Hovde with someone selected by Keating. Gardner checked with his “good friends in the Administration” about whether it was doable. He reports: “Regrettably, the consensus is a bit gloomier … than our earlier prognosis.” Gardner was frustrated that “the President’s illness” means he is concentrating on only a few major priorities, namely, “the budget and tax bills, and the Gorbach[e]v meeting” rather than “our goal of getting some near-term relief for Lincoln.”5
Gardner is a highly partisan Republican writing to another highly partisan Republican, so his negative views about President Reagan are revealing. His greatest frustration is that Gray is a longtime associate of the president. Gray “is unquestionably a disaster but still ‘a nice guy’ to the Reagan inner circle.” The administration cares far more for its cronies than it cares whether they are causing a “disaster.” Gardner writes that Gray, “like so many before him in this Administration, would have to be criminally liable or worse before they [sic] would be removed.” The irony is exquisite. Gardner is complaining to Keating that the principal weakness in their plan to pervert public policy is that the Reagan administration is too tolerant of sleaze and incompetence.
Because they cannot convince Reagan to dismiss Gray, Gardner suggests a revised, two-track strategy. One track is “to make life unbearable for Gray.” The goal is to push Gray to resign. The second track is to destroy the effectiveness of the Bank Board until Gray can be removed. Gardner advises that essential action for both tracks will be to induce the Reagan administration to appoint “your new [Bank] Board Member.” Note the possessive: “your” Bank Board member. Gardner explains the advantages that Keating will derive from having his own Bank Board member.
It would … serve notice on Gray and his staff … that he is out of favor with the White House. This is key since most Reagan-appointed Chairmen of regulatory commissions enjoy great influence over the selection of their fellow commissioners. By robbing Gray of this important perogative [sic], you could hurt him both psychologically and practically, thereby making his early resignation more likely.
Gardner was correct. Note that he understands that the effect will be felt not just by Gray but also by his staff.
Gardner’s next point showed how well he understood agency dynamics.
Chairmen who lose their influence over Board appointments often find that the loyalties of their own staffs become shallow at best. This could temper the action of key FHLBB staff, both in Washington and in … San Francisco.
There are two reasons for this loss of staff loyalty. The chairman is “damaged goods”: he is on the wrong side of the White House because he is following policies they oppose. The chairman may not be able to help loyal staff advance to high-level positions that require White House approval. The new appointee represents the true views of the White House. The staff, seeing which way the wind is blowing, will not want to antagonize the appointee, who may soon be chairman.
Gardner suggested that Keating direct his new appointee to take an active role on Keating’s behalf.
Once confirmed, the Hovde replacement immediately could start to issue strong dissents that could provide your litigators with some good material for appeals to the Federal Courts.
As a litigator who has both defended and brought lawsuits asking the courts to strike down agency regulations, I can confirm that it would be of immense value to control a presidential appointee who would “issue strong dissents” calculated to aid one’s legal case.
Gardner then turned to another key player: the third Bank Board member, Mary Grigsby, a Texan. If Keating’s Bank Board member could get her to vote with him, Keating would have effective control of the board.
With an enlightened Hovde replacement on the horizon, the now-cowed female Member of the Board may take a more independent approach, including occasionally dissenting from the Chairman. The obvious displeasure of Texans, including the Vice President, with the Gray Chairmanship could further enhance this Member’s independence from Gray if she sensed she wasn’t alone.
Other than the sexism, Gardner was again perceptive. George Bush was a major proponent of S&L deregulation, so Gray’s reregulation was anathema to him, and Bush shared the “obvious displeasure” so many Texans had for Gray.
Gardner also understood the importance of other actors, including Congress.
Congressional leaders would have a greatly improved opportunity to show in public hearings the folly of the Gray approach since all three Board Members would be testifying with the replacement presenting an opposing viewpoint to Gray’s. Nothing could better educate Members of Congress and the Administration as to the FHLBB problems and opportunities than an enlightened Board Member who could publicly disagree with Gray.
I testified frequently on behalf of the Bank Board before Congress, and I agree that had Gardner’s plan been implemented successfully our congressional appearances would have been a disaster. Keating’s board member would have attacked our positions and our motives, claiming that we were biased and were suppressing information adverse to our arguments. He would have stressed, accurately, that we were acting contrary to the policies and beliefs of the administration. A public civil war among board members at a congressional hearing would have guaranteed wide, intense media coverage by the major networks and C-SPAN. The chairman always loses in these circumstances: it looks like he is incapable of exercising effective leadership.
Gardner then turned to the other major actor that would be decisive against us, the media.
[T]he PR value of the Hovde replacement would be unlimited…. [Y]our new Board Member could articulate an intelligent approach, and do so with the mantel [sic] of authority that goes along with membership … on the FHLBB.
The press would have had a field day with publicly feuding Bank Board members. Keating’s member would have had instant credibility because of his position. Again, the chairman has to lose in such a war.
Gardner stressed the need “to pursue a number of actions in tandem” in order to “successfully replace Hovde and to simultaneously make life unbearable for Gray.” The actions were mutually reinforcing, designed to force Gray out and to make it impossible for the Bank Board to act against Lincoln Savings in the interim. Appointing Keating’s board member would serve both purposes. The difficulty was that President Reagan was focused on only a few critical items, and Keating’s desires were “barely a bleep [sic] on the far right-hand corner of the White House’s radar screen.” Gardner had a plan to make Keating’s desires a White House priority.
Part of his plan was conventional: intense lobbying of “important members of the Executive branch.” Part of the plan reveals Gardner’s view of George Benston.
Surrogates like Professor Benston should be used to call on key members and staff, and to testify in open Congressional hearings about the counter-productive, re-regulatory approach the Gray Board is pursuing. If we don’t provide articulate surrogates for Lincoln, the robust point of view that you need to have expressed simply won’t occur.
Gardner also suggested that “Gershon Kekst and Company [Keating’s PR firm] mount a major public relations program in responsible print media” against Gray. The idea was to plant stories in the media that could then be “offered as ‘objective’ information pieces for officials of the Executive Branch, Congressional members and even important Kitchen Cabinet members.”
Gardner proposed that Keating use his congressional allies to pressure the administration to appoint Keating’s choice as Hovde’s replacement.
Congressional pressure also should be kept on Don Regan [the president’s chief of staff] and Bob Tuttle [the president’s director of personnel] to insure that the White House feels the real anxiety of key members of the Senate and House about the Hovde replacement. This pressure should start immediately after the Labor Day Recess and continue throughout September and October when the White House will probably be very much in need of Congressional votes on the budget and tax bills. Achieving significant changes in the make-up of the FHLBB by the Christmas recess must become the quid pro quo for some key Members whose votes on these crucial bills will be vital to the White House. (emphasis in original)
Gardner’s plan is to extort the president by holding his top priorities (the tax and budget bills) hostage. Keating must convince key members of the Senate and House to tell the president that they will kill the budget bill or the tax bill unless he appoints Keating’s choice to the Bank Board. Think about that. A senator is supposed to tell President Reagan that he will kill the tax bill, legislation of critical national importance, unless Keating’s demand that he select his own regulator is granted. Gardner understands that it would be difficult for a senator to make this threat credible, which is why he emphasizes the word “real.”
This portion of the letter reveals a great deal about Gardner and Keating and about their views of Gray, Congress, and the Reagan administration. First, Gardner knew that Keating believed he could get senators to condition key votes on whether the administration appointed Keating’s choice to the Bank Board. Gardner had already received enormous sums from Keating and plainly wanted to stay in his employ. He would not have recommended a strategy that Keating would view as absurd. This demonstrates that Gardner and Keating believed that they had enormous influence over the senators. Second, Gardner thought it was realistic that the White House would give in to such extortion (particularly if the publicity campaign to tarnish Gray’s reputation were successful). Third, it is clear that neutralizing and then removing Gray was Keating’s sole priority. Think of the political capital that Keating was willing to expend in this effort. Keating had senators who would kill critical national legislation on his behalf, and he was prepared to use up all those chits to get rid of Gray faster. These two partisan Republicans, purported Reaganites, were willing to prevent implementation of Reagan’s top priorities if they felt it would help Keating remain in charge of Lincoln Savings.
Gardner’s plan to ruin Gray’s reputation was cleverly designed to intimidate the Bank Board and throw sand into its gears without revealing Lincoln Savings’ hand.
We should use every possible hearing (oversight or routine) as a means of assaulting Gray through planted, informed questions. The recent Dingell Oversight Hearing illustrated the aggressive approach that we should be taking behind the scenes to make Gray, his staff, and other Board Members feel extremely uncomfortable about current FHLBB operations. If done properly, the Board Members should not necessarily know what segment of the industry is generating the heat, only that the heat is there and will be increasing. Following each of these hearings, letters asking for additional information should inundate Gray’s office from appropriate Congressional sources. Together, these efforts should make Gray feel very much under attack by responsible members of Congress.
It is remarkable how well Gardner’s revised plan anticipated the future and how much fidelity Keating showed to the revised plan. Keating improvised, always in the direction of making the plan more audacious, but the key elements of the plan were implemented as Gardner had proposed.
Gardner’s letter shows that parts of the original plan were implemented before it was written. Keating and Gardner had developed the overall plan in earlier conversations. The 1985 Dingell hearing is cited as an example of how to hit the Bank Board and Gray secretly. John Dingell regularly won polls in this era as the “most feared member of Congress” (Barry 1989).6 He is very bright and often nasty. When the Democrats controlled the House and he was chairman of the Energy and Commerce Committee, he took an imperial view of his jurisdiction, and was noted for his extraordinarily adversarial investigative hearings. Dingell had just held hearings on the Bank Board’s poor performance concerning Beverly Hills Savings. Dingell had flayed the Bank Board quite effectively. Gardner’s letter (and the reports of Jim Grogan, Keating’s top lobbyist) show that Lincoln Savings’ lawyers helped prime him for assaulting Gray through “planted, informed questions … behind the scene.” The Bank Board’s general counsel was humiliated. Dingell proceeded to conduct a series of equally aggressive hearings on failed S&Ls, including one in which he threatened to jail me. After each hearing, Dingell followed up with an enormous demand for confidential documents to be produced under impossible deadlines. Keating followed Gardner’s game plan, and it seemed to be working even better than they could have hoped.
Gray was attacked at a series of hostile congressional hearings. Dingell chaired some, but not all, of these. They were followed up with demands for masses of agency documents on very short notice. What of the other elements of the plan? They were followed rather faithfully. News stories attacking Gray were regularly planted, particularly with Kathleen Day, a business reporter with the Washington Post, It is likely that they were then presented to key leaders in the executive branch, Congress, and the kitchen cabinet. Gardner had proposed hitting Gray with a coup de main (a hard, unexpected strike) by placing Keating’s member on the Bank Board. Keating decided to stage a coup d’état: he would take control of the Bank Board and topple Gray by convincing President Reagan to appoint two Bank Board members selected by Keating. That would give him majority control over the Bank Board.
Keating’s attacks on Gray and the Bank Board had important consequences, but not the ones he intended. The goal was to intimidate Gray into failing to act against Lincoln Savings or to discredit any action he proposed. The lesser goal was to tie up the agency by having it meet congressional demands for documents. Keating attained his lesser goal, but that just meant that Bank Board staff worked even harder to meet the congressional deadlines. His tactics failed to achieve his primary goal because he did not understand that hard-hitting attacks on the agency in 1985 would have to be premised on its regulatory laxity, not oppressiveness.
Indeed, Gardner’s strategy had already backfired by the time he wrote the letter. Dingell’s criticism of the agency was embarrassing, but it led to greater regulatory toughness. Gardner’s tactics assumed that he could intimidate Gray through a drumbeat of criticism and that the nature of the attacks was not critical. Gardner was happy because Dingell’s attack was intense and embarrassing to the Bank Board. As a result of Dingell’s attack, Gray required supervisory agents to refer all unresolved, substantial violations of rules or materially unsafe or unsound practices to Washington, D.C., and then either to request enforcement or to explain why enforcement was inappropriate. This part of Gardner’s plan proved the old adage: be careful in what you ask for, for you may receive it.
The series of congressional hearings that Keating helped spur had several important chance effects that affected Keating in ways no one could have anticipated. The most improbable result was that Dingell eventually came to view Gray and the agency favorably, and he helped Gray in the struggle with Speaker Wright (who became an ally of Keating’s).
The hearings also changed my role in Washington. After the first Dingell hearing, which so embarrassed the agency and our general counsel, I was tasked with representing our witnesses as counsel at the next hearing. I thought the questioning was abusive and misleading at many points, and spoke up to object to such questions. Dingell had a standard way of trying to intimidate lawyers at such moments: he swore them in as witnesses. The Democratic members of the committee would then pound the lawyer with a barrage of hostile questions. (One of the key reasons Dingell was so effective in using his investigative committee was that the Republicans on the Committee were intimidated by him and did not protect administration witnesses.) Dingell even threatened to put me in the congressional lockup until the end of the session!
The premise of Dingell’s attack, however, was wrong. He assumed that we were pushing the cover-up and would testify that the industry and the FSLIC were in fine shape. I was able to turn the tables on him by stressing that our testimony was exactly the opposite. I took him through all the reregulatory steps Gray had taken and all the steps to toughen supervision that he had implemented before Dingell had announced the first hearing. I explained how Gray’s actions had caused him and the agency to be viewed as the enemy and attacked by the industry, particularly the high fliers. Without saying it explicitly, I got the idea across that Gray had taken on the Reagan administration by backing reregulation. Dingell favored Gray’s approach. It made no sense for him (a Democrat) to attack Gray.7
The second Dingell hearing caused me to become involved in a whole series of issues involving Keating and Speaker Wright. Keating and Wright developed a common antipathy to Gray and me that helped make them allies. No one could have predicted such an improbable chain of events.
Keating’s strategy of using the Dingell hearings to attack Gray had another unintended effect that helped Keating. In response to Dingell’s criticisms of the lack of timely, vigorous regulatory action against Beverly Hills Savings, Gray looked around for acts he could take quickly to emphasize his commitment to toughness. He decided to make the enforcement attorneys (who, like the litigators, were a sub-subunit in the Office of General Counsel) into a separate office reporting directly to the chairman. Responding to the pressure from Dingell, Gray immediately promoted the associate general counsel in charge of the enforcement staff to the rank of office director (the equivalent of a two-level promotion). That attorney was Rosemary Stewart, and within the Bank Board she became Keating’s most aggressive defender and the primary opponent of the FHLB in San Francisco (FHLBSF) in general and me in particular. The irony, therefore, is that Keating’s strategy thrust fairly junior staffers—one who would become his leading agency opponent and one his principal proponent—into senior roles.
By early 1986, Keating realized that he had a chance to take majority control of the Bank Board. No S&L would be closed, no enforcement action taken, and no regulation adopted without the approval of Keating’s members. They would also be able to repeal any existing rule. It would not matter whether Gray stayed, for he would be powerless. Moreover, Keating’s capture of the Bank Board would be so humiliating that Gray would almost certainly resign. Keating could defraud Lincoln Savings with complete impunity.
Keating chose two replacements for Hovde and Grigsby. The first was George Benston, Lincoln Savings’ “surrogate.” Benston was also attractive to Keating because the law forbade all three Bank Board members to come from the same party. Benston was a Democrat, albeit a Reagan Democrat.
Keating’s other choice was Lee Henkel. Henkel was a Republican from Georgia who had worked for Keating when he ran former Texas governor John Connally’s campaign to be nominated as the Republican Party’s candidate for president. He was a tax lawyer who had held a senior position with the IRS. Henkel and his law firm did legal work for Lincoln Savings. Henkel was a joint-venture partner with Lincoln Savings in real estate deals. (Importantly, a joint venture was a direct investment under the Bank Board rule that Keating was determined to destroy.) Henkel was also a large, uncreditworthy borrower from Lincoln Savings.
One of the least-understood facts about the S&L debacle is how close the nation came to a Japanese-style banking industry disaster. The S&L debacle was one of the greatest financial scandals in U.S. history, and the $150 billion loss was enormous, but it was still quite small compared with the size of our economy, which is measured in the trillions of dollars. The S&L debacle had only a small effect on our overall economy, but only because, as I explained in Chapter 3, Gray reregulated.
Consider what the result would have been if Keating had gained control of the Bank Board. Gray’s rules would have been promptly rescinded. Keating was a bitter opponent of the FHLBs. Gray’s major supervisory reforms were the transfer of the Bank Board’s examination function to the FHLBs (with the accompanying requirement to double the number of examiners and supervisors and to increase examiners’ pay) and the hiring of individuals known for their supervisory rigor for key positions at the FHLBs. Keating would have killed all of those steps. Gray was also pushing for much tougher enforcement and vigorous litigation against those who had caused S&L failures through abusive or criminal acts. Keating’s position was that enforcement and litigation were already too severe and abusive. Gray had tightened the rules to prevent the entry of real estate developers with conflicts of interests into the S&L industry and to eliminate new Texas- and California-chartered S&Ls. Keating called traditional S&L CEOs “morons” and said that the answer to the problems of the industry was to encourage more real estate developers to emulate his purchase of Lincoln Savings.
Gardner reported that Keating’s war against Gray had substantial support within the Reagan administration. The three strongest areas of that support were Donald Regan, the OMB, and the office of the vice president (George Bush). Don Regan was Keating’s “go-to guy” in the administration. Don Regan overruled Tuttle’s recommendation that Henkel not be appointed, saying that the administration owed Senator DeConcini a reward for his support (U.S. Senate Committee 1990–1991a, 3:705–707).8 The reward was for DeConcini’s absenting himself from the 1986 vote on Judge Manion’s nomination. The nomination was approved by one vote.
Manion was an odd person to be the fulcrum that gave Keating the leverage to move the administration into giving him de facto control over the Bank Board. The Republicans controlled the Senate Judiciary Committee in 1986, but Manion could not get a committee vote recommending his nomination. He was an inexperienced lawyer who would normally not have been considered ready for an appointment to a federal appeals court. If the nomination failed, the president could have chosen among dozens of experienced, conservative Republican jurists who would have easily won Senate confirmation. There was no policy reason for the administration to make his nomination a major issue.
Keating and Gardner played their cards well: they found a vote that the administration felt it needed to win and a situation where one or two votes (and Keating represented that he could deliver five senate votes) would prove decisive. Keating and DeConcini even found a way in which DeConcini could provide the winning margin without having to vote for the administration. From their perspective, this was an elegant solution.
It should have been a troubling solution from the administration’s perspective. Gardner had assumed that Keating would have to demonstrate the willingness, ability, and intent to kill the administration’s two top priorities (the budget and taxes) to induce President Reagan to appoint a single Bank Board member of Keating’s choice. Instead, the administration was willing to give Keating majority control of the Bank Board (by appointing two members selected by Keating), and all Keating had had to do was hold hostage Manion’s appointment to the U.S. Court of Appeals for the Seventh Circuit. The administration sold its soul to Charles Keating (a fair approximation of the devil) for Manion.9
The administration was about to appoint both Benston and Henkel to the agency on a recess basis. Benston got all the way to the official “intent to nominate” stage when random political opposition killed his nomination. The administration was still desperate to get another nominee on the Bank Board to outvote Gray, so they asked Benston to recommend a deregulatory Democrat who could be appointed quickly. He suggested Larry White, who had undergone the security checks and was about to be appointed to another agency. The administration appointed Henkel and White at the same time in late 1986. Grigsby and Hovde both resigned before these appointments, so without a quorum Gray was left helpless to take vital actions for a time. The timing seemed perfect for the administration and Keating. The direct investment rule had a “sunset” provision, and it would expire if not renewed by the Bank Board by the close of 1986. That was the rule Keating most hated (because he violated it so egregiously), and the administration opposed it as well. With two new deregulatory votes, the rule looked doomed.
We knew Keating had gotten Henkel appointed to the agency and that Henkel had enormous conflicts of interest, but there seemed to be nothing we could do about it, and there was no chance of getting his vote. Henkel’s first major act was to propose an amendment to the direct investment rule. The amendment, which had been secretly drafted by Lincoln Savings’ lawyers, would have surreptitiously immunized Lincoln Savings from sanctions for its massive—$600 million—violation of the rule. I was the only one at the Bank Board to identify what Henkel was up to. I blew the whistle on Henkel, which led to his resignation in disgrace and eventually to an order by the Bank Board’s successor agency removing him from the industry. Remarkably, the administration officially nominated him for a full four-year term after I blew the whistle, after they knew of his conflicts of interest and misdeeds, and after they knew that Lincoln Savings was in massive violation of the direct-investment rule.
Keating had invested enormous political capital in getting the administration to appoint Henkel, and he would have been immensely valuable as Keating’s mole. All of this was lost when we exposed Henkel’s misconduct. Keating now viewed me as his greatest problem.
Keating’s real problem was that Bob Sahadi (the Bank Board’s chief economist) and I won White’s support for reregulation.10 White has a keen mind and was open to ideas that challenged his initial positions. Our efforts to improve the Bank Board’s research on direct investments, including designing and saving the key studies, were critical to this process. White was a deregulatory economist. He was initially suspicious of Gray and reregulation. The administration and Benston had reason to be confident that he would vote against Gray. At the Justice Department he had supported efforts to reduce substantially the circumstances under which it would bring antitrust actions. We had to have Larry White’s vote to achieve further reregulation, because Henkel was a lost cause.
On Keating’s behalf, Benston continued to file comments opposing the proposed equity-risk rule. His first study (in 1984) praised a group of S&Ls that had made material direct investments. They reported high profits. By 1987, however, when Gray and White passed a rule further restricting equity-risk investments, most of those S&Ls had failed. Many were control frauds. Indeed, all thirty-three of the S&Ls that Benston labeled safe and profitable failed (Mayer 1990, 139–140).11
In addition to the rule raising capital requirements and restricting growth, Gray’s invigoration of supervision and examination was his critical contribution to the war against the control frauds. This inevitably led the political allies of the control frauds to launch a counterattack. That had terrible consequences for individual supervisors and for the taxpayers, but we knew it was a battle we would have to fight. The intra-agency civil war was unexpected and much more painful. The irony is that our enforcement director’s ethical views caused her to view the people fighting the control frauds as the villains and the frauds as the victims. Stewart was convinced that Bank Board supervisors were too ready to abuse individuals’ rights and that her ethical duty as head of enforcement was to exercise independent judgment to prevent this ever-present danger.
Regulators can be unprincipled and abusive, and ethical heads of enforcement and prosecutorial bodies should be an important check on such tyranny. But Stewart’s view was idiosyncratic. Every independent scholar says that prior to Gray’s bringing in tough new supervisors from the Office of the Comptroller of the Currency (OCC), Bank Board supervision was shockingly weak (NCFIRRE 1993a). Stewart’s contrary views were first driven home to me in connection with Consolidated Savings Bank, a California control fraud. Consolidated was unusual in that the FBI warned us that “mob associates” ran the S&L. The number two officer, Mr. Angotti, told an FHLBSF examiner that he hoped the agency wasn’t going to take over the S&L because if it did, someone was going to get hurt, and he hoped it wasn’t the examiner! This sent shock waves though the examination team and the FHLBSF. They pulled the examiners out of the S&L and requested emergency action by the Office of Enforcement (OE). Stewart declined, and told the FHLBSF to go to the top officer at Consolidated, Mr. Ferrante, and complain about Angotti. Ferrante was famous for having survived a semiprofessional “hit” at close range from the front. He screamed, while bleeding profusely, at the police that he wouldn’t help any (obscenity deleted) cops. The FHLBSF was amazed and appalled at Stewart’s lack of support on such a critical matter. They called me and asked whether the litigation department could help. We pulled out all the stops and soon got a temporary restraining order against the threats.
The new supervisors were generally dismayed at the approach that the OE took. It was extraordinarily risk averse about losing a case, so it rarely brought any that might be contested (NCFIRRE 1993a, 51). That meant that its attorneys never developed much trial experience. The office generally did not seek to hire experienced trial attorneys for in-house positions, and it refused to use experienced outside counsel.
And it drove the former OCC supervisors berserk when Stewart flatly told them that they were not clients. She said that “the agency” was the client, which meant that she was free to substitute her supervisory judgment for that of the senior field supervisors. The only way they could stop this was to have the chairman personally overrule her supervisory judgment. You cannot take dozens of enforcement disputes to the chairman for resolution without ruining the agency, so as a practical matter she was saying she could not be reversed. She had no training or experience as a supervisor, and her supervisory judgment was consistently in favor of weaker sanctions. She interpreted senior supervisors’ protests at this laxity as proof that her ethical restraints were, in fact, needed to protect against frequent abuses.
Although Stewart had no supervisory experience, Mike Patriarca, who Gray had hired to run the FHLBSF’s supervision department, was a former OCC enforcement attorney. He was in a very good position to evaluate her work and to compare it to that of OCC enforcement attorneys. His view of her was scathing.
Gray had bypassed any competitive selection process to elevate Stewart to office head in order to protect his rear politically after being savaged by Dingell. I considered her work and attitude disastrous for the agency. Julie Williams, the senior Bank Board attorney responsible for securities law compliance, shared that view. One of the telling things for me was that attorneys representing S&Ls that our supervisors had identified as control frauds tried to get the OE involved. At most agencies, regulatory lawyers fight desperately to resolve disputes without coming to the attention of the enforcement attorneys. An enforcement staff is supposed to be like the pit bull that you keep on a chain: there is an implicit threat that you will let it loose if the violators don’t clean up their act voluntarily. When they succeeded in bringing the OE into the case, the control frauds’ attorneys would go on at length about how delighted they were to have Stewart involved because they knew how fair she was. She believed them. Either she was blind to how that would make the supervisors seethe, or she interpreted their displeasure as more proof of their ethical flaws.
A clash was coming, and Lincoln Savings sparked it. There were three causes célèbres involving Lincoln Savings and Stewart during Gray’s term. First, she was enraged when I blew the whistle on Henkel. Her rage was directed entirely at Gray and me; she never indicated any distress with Henkel or Keating. To her, Henkel and Keating were the victims.
Second, when the FHLBSF examiners began disclosing Keating’s frauds in 1986, he responded with an unprecedented tactic. His litigation attorneys announced that the examiners could no longer examine the S&L’s books and records or question its personnel. The examiners could request materials, and if Keating’s litigator decided that the Bank Board needed to see the files, they might be provided. The statute, as one would expect, gives the Bank Board an absolute right to examine all aspects of any S&L. Keating’s unlawful actions, if not ended promptly, would have created a terrible precedent, one that would have destroyed examination effectiveness. Any normal regulator would have realized that if an examination discovered one fraud, there was certain to be far worse information that the S&L was desperate to avoid being uncovered, and the scope of the examination should be expanded.
Stewart, however, would not take any enforcement action. Substituting her supervisory judgment for the examiners’ once more, she decided that if the litigation attorney was based at Lincoln Savings in California, instead of in New York, the FHLBSF had to comply with the attorney’s demands. This can have come only from her view that Keating was the victim and Patriarca the villain. The meeting that led to this settlement distressed me because Stewart allowed Lincoln’s top outside litigator, Peter Fishbein, to, in essence, depose the unprepared and unsupported FHLBSF head of examination. I concluded that Stewart had no litigation sense.
A third incident enraged Stewart. Recall that Lincoln Savings was a captive of Drexel and had no involvement in decisions about its massive junk-bond portfolio. That was a major problem because, as Milken himself emphasized, a junk bond is really a commercial loan. Bank Board rules required an S&L to perform careful underwriting prior to making a commercial loan. Lincoln Savings had done no underwriting, which the FHLBSF examiners were sure to spot. Lincoln Savings decided, as always, that more deceit was the solution. Arthur Andersen was Lincoln Savings’ auditor. The S&L now hired a large group of Andersen consultants to create what would appear to be contemporary underwriting documents.12
The amazing fact about this elegant fraud is that the FHLBSF discovered it. Specifically, Bart Dzivi noticed that the documents were not in a logical numerical sequence and spotted one place (in thousands of pages) where Andersen had mistakenly shown a date subsequent to the junk bond purchase.13 Bart spotted it and understood the significance.
The FHLBSF alerted the OE to the fraud and the possible backdating and forging of documents. The OE received formal examination authority from the Bank Board and then did nothing. It did not take testimony from a single witness. The FHLBSF general counsel was about to leave in early 1987; the office offered me the position and flew me out to try to convince me to take it. I met with Mike Patriarca. He asked me to talk to Gray about two things: he wanted Gray to end the insane interest-rate gamble that American Savings was taking, and he wanted enforcement action taken against Lincoln Savings.
I talked with Gray; he was ready to end the gamble and sell American Savings quickly. But he wanted nothing to do with directing Stewart to take action against Lincoln Savings. He told me to talk with my superiors in the Office of General Counsel. They arranged a meeting with Stewart’s deputy, Steve Hershkowitz, who was handling the Lincoln Savings case. It was enlightening. I said that Mike Patriarca wanted to know when the OE was going to begin deposing witnesses. Steve said he might not take any depositions and that, in any event, it was not a priority matter. I was staggered; I told Steve that it was one of the highest priorities of the S&L’s top supervisor. He responded that Lincoln Savings wasn’t a priority matter because it wasn’t insolvent. I replied, “Actually, Steve we like to keep it that way.” He also said that the allegations didn’t indicate any problems with management’s integrity. I said that the allegations of file stuffing and document backdating certainly reflected on integrity. He told me that “those allegations haven’t been proven.” I replied, “That’s why we do investigations.”
Eventually, I had to assign one of my experienced litigators, Anne Sobol, to conduct the investigation (under Stewart’s control). Sobol used outside counsel to assist with the investigation. The depositions revealed extensive forgeries and backdated documents, and documented the junk bond “file stuffing.” This led to criminal referrals and eventually to felony pleas. The effect on Stewart, however, was to convince her that I was the prime villain and that Keating was somehow not very culpable.
I became convinced that Stewart was the greatest internal impediment to the accomplishment of the agency’s mission. I considered the OE to be the land of the invertebrates. Patriarca and I pushed for Gray to move her to the side and bring in a vigorous enforcement director. Gray’s term, however, was about to end, and Larry White did not want any major personnel changes before Danny Wall arrived as the new chairman. Gray elected not to proceed. It probably wouldn’t have done any good if he had. Wall saw Gray’s and my criticism of Stewart as the greatest possible endorsement of her. The stage was set for a broadscale civil war.