1. My regulatory career is profiled in Chapter 2 of Riccucci’s study (1995).
1. I use the term “CEO” because it is short and because CEOs typically control companies. I use “he” as the pronoun for CEO for similar reasons.
2. I do not assume that individuals are perfectly rational in evaluating risk. Individuals frequently misapprehend risks. It is enough for my purposes that they try to avoid situations in which detection and punishment of fraud is most likely.
3. A straw is someone who fronts for the real person at interest. An S&L generally cannot loan money to its CEO. The CEO finds an acquaintance who will sign the loan documents but give the proceeds to the CEO.
4. The same dynamic caused the current glut of broadband capacity.
5. The rule banning ARMs was not a product of S&L domination of the Bank Board. To the contrary, the industry, the agency, several presidents, and most of Congress wanted to overturn the ban on ARMs in order to reduce the industry’s systemic exposure to interest-rate risk. The ban remained, however, because the powerful National Association of Home Builders and the National Association of Realtors (normally allies of the S&L trade association) feared that ARMs would reduce home purchases. The NAHB and NAR lobbied “proconsumer” congressional chairmen to block Bank Board approval of ARMs.
6. In addition to being awful economics and accounting, loan loss deferral was poor policy. It encouraged S&Ls to sell their home mortgages at enormous losses that locked in their real insolvency. The owners knew that the S&L was hopelessly insolvent and that its reported profits were fictitious. “Profits” occurred solely because the deferred recognition of loan losses led to real losses being dramatically underreported. The owners also knew that the fictitious profits would disappear in about five years. Deferral, therefore, prompted two disastrous responses. First, S&Ls sold mortgages at what was likely to be the worst possible time (which magnified the eventual losses of the FSLIC). Second, there was a powerful incentive to engage in reactive control fraud.
7. An arbitrage is a risk-free exchange, so an RCA is a self-contradiction. There were no arbitrages available to S&Ls. Stripped of the veneer of financial mumbo jumbo that the task force tacked on to the proposal, an RCA was an instrument that grew rapidly and took moderate interest-rate risk. Loan loss deferral and RCAs are, however, contradictory proposals, a fact that escaped the task force’s analysis. An RCA would prove profitable if interest rates fell; it would greatly increase losses if they rose. But if the agency was relying on a near-term fall in interest rates, then the last thing it should have done was to adopt loss deferral, which encouraged S&Ls to sell their traditional mortgages at large, real losses. If S&Ls held the mortgages and rates fell sharply, they would make enormous gains. This policy incoherence was characteristic of Pratt’s tenure. His motif was to do everything possible for the industry even if the components were logically inconsistent.
8. Ed Kane (1985), however, predicted very early that the industry was headed for disaster, but he did not tie that accurate prediction to opposition to deregulation.
9. This political risk extended to Vice President Bush, for he was Reagan’s head of financial deregulation.
10. For example, our analysts knew that the Soviet Union was deploying nuclear missiles in Cuba because our U-2s spotted the characteristic pattern of antiaircraft defenses the Soviets always used for nuclear missiles.
11. The same thing happened to the SEC in the 1990s. It became so short-staffed that it never knew a wave of control frauds had hit. It never identified patterns of conduct indicating that fraud was likely.
12. This provided a wonderful sight gag in Jurassic Park (Spielberg, 1993). The camera shows a view in a passenger-side mirror of the still-distant Tyrannosaurus rex pursuing the jeep and then cuts to a direct view of the action in which the T. rex is terrifyingly close.
13. Humbert Wolfe (1886–1940), “Over the Fire,” from The Uncelestial City (New York: Alfred A. Knopf, 1930).
1. Market value means just that. You assign current market prices to your assets and liabilities. A long-term fixed-rate debt loses much of its market value if interest rates increase sharply. Interest rates did that in 1979–1982, so S&Ls, with their 30-year fixed-rate mortgages, became massively insolvent.
2. Supply-siders argue that reduced taxes lead to economic and tax-revenue growth that will eliminate deficits. Bush aptly termed this “voodoo economics” when he was running against Reagan for the 1980 presidential nomination. The 1981 tax cuts led to record deficits.
3. GAAP changed subsequently to require recognition of these market-value losses. During the debacle, however, GAAP used the original or book-value basis for assets as long as they were held for investment (as opposed to sale or trading). S&Ls always claimed that they were holding for investment.
4. S&L mergers used “purchase” (often called “push down”) accounting (rather than “pooling”).
5. S&L liabilities were so short-term that they reflected market value and were unaffected by the “mark.”
6. How often does the IRS provide a lagniappe? Is this a great country or what?
7. Discount was a “contra asset.” It reflected the fact that even though the mortgages had a new (lower) GAAP basis after the mark-to-market, they could still pay off in full at their initial book value. Assume that in 1977 one bought a home with a $200,000 mortgage at an 8 percent interest rate, and then sold it in 1983 when the comparable mortgage interest rate was 14 percent and the market value of the mortgage was $160,000. One pays the S&L the contractual amount ($200,000 less down payment and amortized interest), not the reduced market value. (This assumes that the buyer does not assume the mortgage.) “Discount” provided the accounting mechanism to recognize the value of mortgage prepayments.
8. S&Ls amortized goodwill on a straight-line basis over forty years. Pratt ended the Bank Board rule that had limited amortization to a maximum of fifteen years, and he used creative RAP to continue the forty-year period even after the accounting profession revised GAAP to require a faster write-off of goodwill.
9. Discount was “accreted” to income over a much shorter time than forty years.
10. Accountants refer to this as a “timing difference.” That is quite a euphemism in this context, for few acquirers were likely to survive long enough to have the curves “cross over.”
11. To estimate the fictional accounting gain from discount, however, one also has to remember that the acquirer in my hypothetical was acquiring a net liability. Acquiring a net liability depresses real operating results. Taking this into consideration, the more insolvent the S&L acquired, the greater the fictional net income and the worse the cash position.
12. One got a bonus at the Bank Board by being “creative” or working exceptionally hard. Creative often meant finding a new way to abuse accounting. Working hard usually meant spending nights and weekends getting new goodwill mergers and new conversions from mutual to stock ownership approved. In the field, it meant finding someone willing to be a goodwill acquirer. The Bank Board under Pratt constantly reinforced the message that traditional S&Ls were the problem, that new entrants were “entrepreneurs” and the solution, that abusing accounting was “clever” or “innovative” instead of immoral, and that the Bank Board’s policies had brilliantly resolved the crisis. The Bank Board staff loved Pratt. He was quick, generous with praise, quick to make fun of himself, demanding, and hardworking. Pratt didn’t intimidate staff members into agreeing with him; he swept them off their feet and turned them into disciples eager to spread his message and methods. This made the Bank Board staff certain not to see the new entrants as criminals. I asked an agency old-timer in 1985 how many “changes of control” the Bank Board had denied in her institutional memory; the answer was one.
13. For example, in 1988 the FHLB in San Francisco recommended Mera-Bank as an acceptable acquirer for three failed Texas S&Ls. The senior supervisor, Eric Shand, however, felt that something was wrong and asked me to look at the matter. It turned out that not only was MeraBank insolvent except for its (fictitious) goodwill, but that it was also operating at a loss, once the (fictitious) income from the accretion of discount was removed. Our line supervisors had not understood goodwill accounting. We changed our recommendation and notified the Bank Board that MeraBank would fail. Wall was furious at us and approved the acquisitions. MeraBank soon failed. In 1992, an experienced agency accountant with from the Dallas region joined our West Region. She was unaware that goodwill accounting produced fictitious income. It was lost knowledge after Pratt left.
14. Here’s an example: year-end total liabilities at an S&L over the last five years were $10 million, $20 million, $30 million, $40 million, and $1 billion. If we measured the 3 percent capital requirement against current liabilities it would be $30 million. With five-year averaging, however, the capital requirement is 3 percent of $1.1 billion (the sum of the total liabilities over the five years) divided by five. The average total liability was $220 million, so the capital requirement is 3 percent of that, $6.6 million, which is slightly more than one-half of one percent of the actual total liabilities of $1 billion. If the S&L had grown more rapidly, the percentage requirement would have been even lower.
15. California legislators stood to lose substantial campaign contributions from S&Ls; a state legislator can neither hurt nor help a federally chartered S&L. The “supremacy clause” of the U.S. Constitution prevents states from restricting federally chartered S&Ls. California S&Ls had just gotten the governor of their dreams, George Deukmejian, elected. They would soon have the California Department of Savings and Loans (CDSL) commissioner of their dreams: Larry Taggart, son of the governor’s largest campaign contributor. They could dominate the CDSL, but if they had to convert to federal charters they would lose influence. The CDSL was funded by assessments on state-chartered S&Ls. The conversion to federal charters devastated the CDSL. It fired three-quarters of its professional staff. The CDSL’s survival depended on the Nolan Act, which had no opponents: all the risk lay with FSLIC, not California.
16. His defense was that he was impotent at the time. It is unlikely that this unique variant of “no harm, no foul” pleased his wife!
1. Deposit brokers existed because of limits on deposit insurance and because S&Ls and banks paid a slightly higher interest rate for jumbo deposits of $100,000 or more. They “sliced and diced” the funds of corporations and very rich customers into fully insured $100,000 deposits at a number of banks or S&Ls. Deposit brokers also consolidated funds from many small depositors into fully insured jumbo accounts.
2. Losing the case was my first major act as the new litigation director. I joined the agency on our eldest child’s second birthday, April 2, 1984.
3. This question was of particular importance to me when I joined the agency as his litigation director. I told him to go ahead. The worst that could happen would be an order to approve FSLIC insurance for the new charters.
4. A direct investment involves an express or implicit ownership interest in the investment, as opposed to being a creditor for the investor. Buying land or shares is a direct investment. Lending money makes one a creditor. There is a critical exception to this last statement that I will explain later.
5. GAAP did not permit this much fee income to be recognized as immediate income, but control frauds routinely did it anyway and got clean opinions. The Bank Board shares in this blame. S&Ls could report additional fee income under RAP.
6. Many current control frauds use an additional mechanism: huge corporate loans made directly to the CEO. The corporation may then forgive the loan or the CEO may fail to repay the loan. S&Ls did not use this device because it was generally unlawful for an S&L to loan money to its CEO.
7. The control frauds had an elegant means of finding bad real estate developers. They maximized “adverse selection.” Economists first identified adverse selection in the insurance context. A company offering insurance against lung cancer faces the risk that the people most likely to buy coverage are the ones most likely to develop lung cancer. Insurance theory and practice have developed means of reducing adverse selection. Control frauds took the opposite steps. The best way to reduce adverse selection in lending is to ensure that the borrower will suffer financially should the loan default and to conduct superior underwriting of the borrower and the real estate project pledged as security for the loan. Control frauds structured ADC loans that required neither a down payment nor a personal guarantee in order to ensure that the borrower would not suffer any direct financial loss. They chose borrowers with poor reputations who would not suffer any indirect financial loss from a loan default, and avoided making loans to high-quality developers.
8. Worse, the United States Court of Appeals for the Fifth Circuit ruled that Arthur Young was not liable to Western Savings’ honest shareholders because Western Savings was a control fraud! The auditors were immune from suit because they helped a control fraud cause a billion dollars in losses to the taxpayers. By protecting top-tier audit firms from liability for aiding control frauds, the courts (and later Congress) helped cause the current wave of scandals.
9. The property could also be real estate owned by the S&L as a result of foreclosing on a defaulted ADC loan.
10. Because a CEO did need not to expressly ask the employee or officer to engage in fraud, everyone enjoyed deniability—and almost no one wants to think of himself or herself as a criminal. People in these situations use all kinds of what criminologists call “neutralization” techniques to keep from looking at themselves as criminals. Control frauds reinforce these techniques. One of the most effective means, which Keating used to good effect, was to tell employees that they were geniuses and that the regulators were dumb, vicious perverts. He paid people well above competitive salaries. His outside professionals were generally top quality, but his in-house people overwhelmingly were graduates of second-tier schools. Telling them that they were geniuses and paying them far more than graduates of top schools at rival banks and S&Ls made for intense loyalty. The other inducement was negative. It is why I say that control frauds are control freaks (Black 2000). Asking questions was the one sure way to get fired by a control fraud. One could make loans with a 96 percent default rate (as happened at Vernon Savings) and get a huge bonus, but ask a question and one was gone. The control frauds hired yes-men and yes-women and got rid of inquiring minds.
Nevertheless, the officers and employees knew that they were helping a fraudulent scheme. People who were unwilling to do so left, and the ones hired to replace them were likely to be less ethical. S&L control frauds deliberately gutted internal controls designed to stop bad loans. It was easy to defraud S&L control frauds.
11. My favorite example of construction fraud victimized Guaranty Savings, an Arkansas control fraud. It disbursed all the loan proceeds—over $30 million—to build an underground health club in Dallas. Even without construction fraud this would have caused a huge loss, but with the fraud, the FSLIC became the owner of a block-long, five-story-deep hole in downtown Dallas. The hole was worse than worthless. If one removes that much dirt, the ground nearby begins to subside, and may collapse into the hole. Such a collapse would rupture water and sewer lines and natural gas pipes. Dumping the dirt back in the hole would not recreate its former condition. Dallas wanted us to spend over $5 million to turn the hole into the world’s biggest concrete post! We, barely, convinced them there was a much cheaper way to compact the dirt safely.
12. Economists are like the guy in the old joke who loses his car keys one night on the north side of the parking lot but searches for them on the south side because the light is better there—they only study where they have data.
13. The context was that I had just lost the case defending the deposit broker rule (on the grounds that we had no statutory authority to adopt the rule).
14. I had useful skills to bring to the reregulatory task. I was a lawyer, so I understood the rules, the legalese, and our litigation opponents’ strategy for overturning the rule. I was an economics major with over 60 semester hours of economics, and the University of Michigan accepted me into its PhD program in economics. (I went to its law school instead.) This did not make me an economist, though I teach microeconomics, but it meant that I was sufficiently fluent in economics to serve as a translator between the lawyers and OPER.
I was also “chief coroner” for the agency. My role as litigation director required me to autopsy every S&L failure in preparation for defending our closure of the S&L against legal challenges and determining whether we should sue the officers, directors, and outside professionals. To do my job, I had to become familiar with how the agency examined and supervised, and I had to learn how S&L accounting and appraisals worked. I found this, having experts explain their fields to me, great fun.
This education process also meant that I developed a broad network of friends who respected me. People are flattered when you take a sincere interest in their field. They are impressed when you link their insights to an aspect of another field with an unforeseen connection and show that the combination produces an elegant Ponzi scheme.
Because I saw every failure, I was among the first to see the emerging failure pattern. The central fact about the high fliers is that virtually all of them were minor variants on the ADC Ponzi theme. Tom Segal, one of my litigation attorneys, also suggested that we establish an “early warning” system. All too often we would learn of a planned closure days before it happened, even though it had been in the works for months. Segal’s suggestion was excellent, and it paid dividends during reregulation because we discovered that our supervisory staff regularly briefed Bank Board members on “significant supervisory cases.” The briefing book was enormous. It had synopses on hundreds of S&Ls, and the worst ones, which I had generally never heard of, also fit the pattern of high-flier failures.
15. Gray did not know me. I had lost the first major case I had handled for him. When I lost the case, he lost his top priority. I was now advising him to defer, for months, his remaining top priorities. He knew, far better than I, that his political opponents would use that delay to savage him. I was the messenger of terrible news. Gray did not kill or abuse the messenger. Two things helped. I had the confidence of the Norm Raiden, who recruited me to the agency, and Norm had Ed’s confidence. I had also advised, as did my predecessor, that we were likely to lose the deposit broker lawsuit.
16. The problem with economic studies of ADC Ponzis was just what I explained: they were certain to report record income. Moreover, few of them had collapsed even by fall 1984, when we reproposed the rules. We had to look at the relatively small group of failures, which is always a problem for statistical analysis, and even for those failures we could not rely on reported income figures, because they were fraudulent. My solution was to study the likelihood and the cost of failure and to show that the S&Ls that grew fastest had the same characteristics as the catastrophic failures.
This required a very difficult dance. I started out with a great deal of credibility with our economists, but they generally had no respect for Gray and reregulation. They knew that their profession would consider them prostitutes if they favored reregulation because regulation was so discredited among economists, and they feared that Keating’s expert economists would end up as peer reviewers of their future academic articles and would trash them. They feared that I was the pimp out to prostitute them. I had to establish why economic theory predicted that control fraud was a rational response and to explain how an ADC Ponzi worked. I also had to make sure that they reviewed every sentence in the preambles discussing the economic arguments. It took time, but it added to my credibility and made them comfortable going forward.
In the process, I got an unusual boost to my credibility by saving two of the OPER studies. In 1984 our economist reported that the study supporting the capital rule, which focused on the problems of excessive growth, did not find the expected relationship. This could have killed the entire rule. I was sure, given my knowledge of the limited number of failures, that the study should show that excessive growth was associated with a host of problems characteristic of our worst failures. I asked to see the data entries. It turned out that OPER had entered data for a number of failures twice. The double-counted ones had shown the expected relationship only very weakly. When those entries were removed, the study offered strong support for the rule.
The second example occurred in 1987 when the Bank Board considered extending and strengthening the direct investment rule. The key OPER study tested whether S&Ls with greater direct investments cost the FSLIC more to resolve when they failed. I had suggested this study design. The OPER econometrician (an economist who specializes in statistics) told me the study found that greater direct investments led to reduced FSLIC expenses. He told me that a number of “outliers” (extreme values) drove this result. He was spending his time working on corrections for the serious heteroskedasticity that arose in large part from these outliers. I asked to see the data plot (which shows graphically each datum). It showed five failures with enormous amounts of direct investment—the largest ones in the entire sample—and the FSLIC had resolved each of them at zero cost! You can see why this would lead to a negative statistical relationship between direct investments and the cost of resolution. Unfortunately, the econometrician had not thought to check, nor had anyone in OPER checked, whether this result could be true. Had he known anything about the S&Ls that the Bank Board was closing, he would have known there was a mistake. To him, however, the closures were simply data, which was why he accepted the nonsensical results and continued calculating.
I asked him to tell me which failures the outliers represented. He looked up the identifier number for the first one and told me “American Diversified Savings Bank.” I smiled. This control fraud had cost the FSLIC almost $1 billion to resolve. (It grew more than 1,000 percent.) The other outliers were all control frauds, and their “zero resolution cost” figures were, of course, wrong. Each of them was a catastrophic failure. The mistake occurred, once more, in data entry. The Bank Board had a new “Management Consignment Program” (MCP) that split the failed S&L’s portfolio into good and bad assets and transferred only the good assets to a newly chartered S&L. The newly chartered S&L got an FSLIC financial guarantee that the good assets really were good. That meant that the newly chartered S&L had a zero (additional) cost of resolution to the FSLIC. The econometrician had entered that zero resolution cost for the five MCPs. The Bank Board generally used the MCP program for the worst failures with substantial direct investments, so these mistaken data entries created a severe bias in the statistical analysis. The econometrician corrected the data entries and the expected result emerged: the greater the amount of direct investment, the greater the cost to the FSLIC to resolve the failure.
1. Gray’s reregulation tightened the standards in 1985.
2. Milken recruited Keating (and other notorious control frauds such as David Paul and Ivan Boesky) to buy state-chartered S&Ls because they could grow massively, buy large amounts of Drexel junk bonds, and serve as Milken’s “captives” (Akerlof and Romer 1993; Black 1993c). The Bank Board, in a rare victory, blocked Boesky’s acquisition of a California-chartered S&L. Keating and Paul, however, became captives. They learned at the end of each day which junk bonds they now owned; they had no involvement in deciding what to buy or sell. Milken got, and exploited, three obvious advantages from his captives. They bought huge amounts of Drexel junk bonds. He churned the accounts (engaged in rapid, repeated trades). These tactics maximized Drexel’s fee income. Milken was able to dump his junkiest junk on his captives. It did not matter that this made Lincoln Savings and CenTrust Savings more insolvent; their failures were certain. It helped Milken dump his biggest losers on his captives (Black 1993c).
The more subtle advantage was that Milken’s control of the captives ensured that public offerings of junk bonds would succeed and that junk bonds issued by Drexel that were about to default would instead be restructured. Milken could cause the captives to purchase whatever junk bonds the market had refused to buy or restructure (Akerlof and Romer 1993). Reducing the reported default rate of a security makes it appear less risky; a bond that appears less risky rises in value. This is not a claim that Drexel ran a Ponzi scheme or that junk bonds were worthless. They were, however, materially overvalued. That made Milken a rich man, even after he was released from prison.
This explains why Milken made substantial efforts to induce control frauds like Keating, Paul, and Boesky to enter the S&L industry. We know from Boesky and Keating how Milken pitched the idea. He told them that a deregulated, state-chartered S&L would make them the equivalent of “a merchant prince” (NCFIRRE 1993, 15). Milken understood his fellow felons.
The Bank Board, however, did not understand Milken until it was too late. Gray’s instincts again caused him to lean the right way. He was deeply suspicious of Milken and wanted to pass rules restricting junk bonds. OPER, however, said they could not support the rule. In this era, even the GAO’s economists opined that junk bonds were an excellent investment (Stein 1992, 134–135). According to OPER, Milken was right: a diversified pool of junk bonds made a superior investment portfolio. Fortunately, S&Ls never held more than 10 percent of outstanding junk bonds (and usually far less), and 90 percent of all those junk bonds were held by a dozen S&Ls, all of which failed (Black 1993c; NCFIRRE 1993, 4). Many at the agency saw Lincoln’s billion-dollar portfolio of junk bonds as a warning sign, but OPER did not. There were rumors that Drexel had captives, but that fact had not yet been proven.
3. The White House director of personnel told the Senate Ethics Committee investigating the Keating Five that he learned this when he inquired about Keating’s reputation in Arizona (U.S. Senate Committee 1991, 3:705–707).
4. Greenmail is a form of extortion. The “corporate raider” buys a large stock position in the target firm and threatens a hostile takeover. The target firm’s executives, who fear losing their high-status, high-pay positions if the takeover succeeds, cause the firm to buy back the raider’s shares at a premium. Lincoln Savings bought a great deal of Gulf Broadcasting stock at above the market price. This investment could have easily rendered Lincoln Savings insolvent if the shares had fallen even slightly in price. It was a grossly imprudent investment for an S&L that had little or no capital. Gulf Broadcasting eventually bought Lincoln Savings’ stock position at a premium, so the greenmail succeeded.
5. The tone of the letter is surreal: Gardner implies that Reagan should have been concentrating on assisting Keating instead of “the budget and tax bills, and the Gorbach[e]v meeting.”
6. John Dingell is a Democratic congressman representing my hometown, Dearborn, Michigan (our neighbor directly across the street hosted a neighborhood meeting with him when I was a teenager).
7. By standing up to Dingell and launching a somewhat impassioned defense of the agency, Gray and I gained considerable stature within the agency. We had all been feeling down because Dingell had been able to embarrass the agency at the first hearing, and now we were fighting back and getting some respect for it from Dingell. Gray liked it, of course, because it was a defense of him and his agency. He circulated my remarks to the FHLB presidents. I had already been playing a wider and more prominent role at the agency because of my work on the critical reregulation rules, but after the second Dingell hearing I took on a prominent role at most of the key congressional hearings during Gray’s term. He also frequently used me to head his highest-priority projects, even if they had no litigation component.
8. In 1984, Keating began recruiting the senators who would become known as the “Keating Five.” Keating was an Arizona real estate developer, famous for making large political contributions. Senator DeConcini represented Arizona, and Keating contributed substantially to his campaigns. DeConcini became Keating’s earliest and most loyal Senate patron, even though Keating was a Republican and DeConcini was a Democrat.
9. When I learned about this incident in 1990, it immediately reminded me of the devastating insult in A Man for all Seasons, Richard Rich perjures himself to provide the evidence that condemns Sir Thomas More. Rich passes by More as he leaves the witness box and More notices that he is wearing a new chain of office. He asks what it is and is told that Rich has just been appointed “Attorney-General for Wales.” More responds, “Why, Richard, it profits a man nothing to give his soul for the whole world. [pause] But for Wales!” (Bolt 1990, 92). But for Manion!
10. I participated in the economic and econometric discussion at the Bank Board meeting when we adopted the tougher equity-risk investment rule to replace the direct investment rule. After the meeting, Larry White asked me, “You’re ABD (all but dissertation) in economics, right? Where did you study?” I had to explain that I was “ABE” (all but everything!).
11. His other studies fared no better. The results of one strongly supported our position on the risks posed by such investments. His comments concluded that the finding was meaningless because it was not statistically significant. I looked at the values he reported and told our economists that my “quick and dirty” review (without the necessary tables) showed that the study was statistically significant very near the 90 percent confidence interval. They checked and it was. Shocked, they lost confidence in his work.
12. Recall that the fraud that led to Andersen’s well-deserved demise involved destroying records after Enron’s failure was made public. The document destruction was unlawful, but it did not harm investors. At Lincoln Savings, Andersen did something far worse: it helped keep a control fraud in operation, a control fraud that cost the taxpayers $3 billion.
13. A true, contemporaneous underwriting document could not have such information.
1. I am biased, but I think that the contrast between the following excerpts from Barry’s book (1989) reveal his central bias. The first description is of Marshall Lynam, Wright’s number two aide, the second is of me (a Wright critic):
Tall, lean, white-bearded, only a few years younger than Wright, he handled Wright’s personal business and constituent services. (72)
He was a full-bearded man in a city where beards were a badge of nonconformity, a leftover from the sixties. (236)
If you support Wright, a beard is … a beard. If you criticize Wright, a beard is fraught with peril.
2. The GAO had done a series of studies demonstrating that fraud and insider abuse was pervasive at the worst failures and that the control frauds were able to get clean opinions from Big 8 audit firms. The GAO was, rightly, critical of how weak Bank Board regulation, supervision, and enforcement had typically been. The GAO had a generally strong reputation with Congress.
3. Until very recently, any Senator could do this secretly to any bill. There are ways to discharge the freeze, but it is a major obstacle. Such freezes were not common because they invited ruinous retaliation by other senators. Cranston’s freezing a bill of national importance indicates how important Keating viewed the defeat of the FSLIC recap and Proxmire’s measure to be, as well as how beholden Cranston was to Keating. Because the freeze was secret, the Bank Board did not even become aware of it until it was far too late.
Cranston was not the only senator willing to block the FSLIC recap. Senator David Pryor of Arkansas placed his own hold on the bill. Pryor wrote Gray on October 3, 1986:
S&L officials in my state have called to my attention what appears to be a deliberate system of harassment…. Before the Bank Board receives any recapitalization authority from the Congress, you need to assure us that your supervisory resources are being used effectively and fairly…. I have put a “hold” on the Senate recapitalization bill and am anxious to receive assurances from you that you will correct the abuses which have been taking place in Arkansas and other states. I was pleased to learn that you have been discussing this problem with the House Majority Leader [James Wright]. (Mayer 1990, 232)
Pryor’s letter was characteristic of the attitudes of the politicians who intervened with the Bank Board on behalf of the control frauds (which were endemic in Arkansas): it does not ask questions; it pronounces guilt and issues the sentence. But Pryor’s letter is special because, in one of the grand jokes that fate plays, Pryor ended up on the Senate Ethics Committee investigating the Keating Five’s analogous intervention on behalf of Charles Keating. The five senators couldn’t complain of not having a jury of their peers!
4. This is a common practice in which lenders agree to reduce the interest rate and to delay payments. The GAAP accounting rules at that time (FAS 15) were extraordinarily easy to abuse. A lender who approved a “troubled debt restructuring” (TDR) did not have to recognize the loss currently. (When a lender accepts a lower interest rate and delayed payments, it suffers a real, immediate economic loss.) This GAAP treatment was, of course, very attractive to S&Ls that would have had to acknowledge their insolvency if they foreclosed on the defaulting borrower. If they entered into a TDR instead, they could delay recognition of their losses and claim that they were still solvent.
The Bank Board had taken over only one S&L that had lent to Hall, Westwood Savings, but it was the “lead lender” to Hall and had sold “loan participations” to twenty-nine other S&Ls. These S&Ls were eager to agree to the TDR and desperate to prevent any suit against Hall. Wright believed that since the other loan participants favored the TDR, Westwood Savings’ objection to the TDR had to be irrational.
5. Barry offers insight into both Hall’s central argument about the virtues of forbearance and Wright’s (and Barry’s) acceptance and adoption of those arguments. Barry (1989, 217) includes the following as if it were a factual statement:
[Hall’s] bankruptcy would flood the already-depressed Texas real estate market with tens of thousands of condominiums. That would drive real estate values down further and could spark a true depression in Texas.
Hall was bankrupt. That was a fact regardless of whether the parties called him bankrupt. He could not pay his debts when they came due, and his liabilities greatly exceeded his assets. The TDR would reduce his liquidity problems and delay his bankruptcy filing, but he would (and did) end up filing for bankruptcy. The condos would not flood the market when he declared bankruptcy; they were already in the Texas real estate market. Approving the TDR increased the glut by permitting Hall to complete the construction of new units, and caused property values to fall even more than they would have if Westwood had forced him into bankruptcy in 1986.
Wright believed Hall’s experts’ claim that his bankruptcy would “destroy twenty-nine S&Ls” (Barry 1989, 218). In fact, those S&Ls had already failed, and the TDRs locked in that failure. The TDRs, along with Wright’s actions blocking the FSLIC recap, delayed the takeover of the twenty-nine failed S&Ls and greatly increased losses to the taxpayers and the harm to Texas’s economy.
The glut of Texas real estate became much worse in 1987–1988 precisely because Wright delayed closure of so many control frauds (including many of the twenty-nine S&Ls behind Hall). The appointment of federal receivers for those twenty-nine S&Ls in 1986 would have led to similar lawsuits against defaulting borrowers and would have forced dozens of other Texas control frauds to report that they were insolvent. This would have helped bring down the control-fraud daisy chain that added to the glut of real estate in the Southwest and caused tens of billions of dollars in additional losses to the taxpayers every year it stayed in operation.
To defend Wright’s putting a hold on the FSLIC recap, Barry (1989, 218) musters a quotation that is actually a devastating indictment of Wright and Danny Wall.
M. Danny Wall, the Republican staff director of the Senate Banking Committee who succeeded Ed Gray, later told Wright, “We did have a clown in the Craig Hall thing. He would have brought down the daisy chain [of S&Ls in Texas].”
Wall made this statement as Bank Board chairman. The Bank Board’s principal mission was to bring down the daisy chain. Wall and Wright believed that keeping the daisy chain of control frauds open was good for the FSLIC, Texas, and America; this explains why Wall and Wright combined to create one of the worst financial-policy fiascoes in history.
Wall’s disparagement of Schultz as a “clown” is also revealing. Wall, Wright, and Barry have never met Schultz and know nothing of him. They relied on Hall’s view of Schultz. Westwood’s MCP managers decided to sue Hall. Schultz made sure that they considered Hall’s arguments and thoroughly analyzed the options. Schultz then defended the managers’ decision from extortion by powerful politicians (Wright and Wall, who was acting on behalf of Senator Garn) and pressure by Gray and Fairbanks. I cannot understand how any of this could possibly make him a clown.
Schultz went on to spot many of the problems with Lincoln Savings. Keating, like Hall, personally attacked Schultz. Wall never talked to Schultz; he relied on Hall’s and Keating’s criticisms to form his view of Schultz as a clown. I worked with Scott Schultz in both the Hall and the Keating disputes. I found him competent, principled, and brave. World Savings, the best-run S&L in the country, apparently agreed; it hired him away from us.
To Wall (and, it appears, to Wright and Barry), people like Schultz who stick to their guns when it is clear that their bosses and powerful politicians want a contrary result are objects of derision, naïve waifs. The anecdote also displays a weakness inherent in Wall’s management style. A Bank Board employee trying to bring a politically well-connected control fraud to justice would feel no confidence going into the fight if Wall were the one watching her back.
6. Barry does not ponder why Raupe would not pass on such a message, which was clearly a warning to Wright from a highly reputable individual who was no friend of Gray’s. Raupe was Wright’s best friend and, according to Barry, the only aide who had the guts to disagree with Wright. Barry asked Raupe about this conversation with Smith several years later, at a point when it would have been intensely embarrassing for the Speaker to ignore such a warning.
7. The national recession of the early 1990s and the cut in defense spending made possible by the fall of the Soviet Union caused California real estate values to drop. One of the important reasons that the California real estate recession was far less severe than that in Texas is that the California control frauds were closed or brought under control well before the recession hit. As Chapter 4 explains, control frauds followed the same practices in California and Texas and failed for the same reasons, even when they were lending to a vibrant real estate market.
1. Barry is very sympathetic to Mack. He quotes favorably a reporter who chastised the Washington Post for running a story that exposed Mack’s background because the paper was making itself a party to an act of “vengeance” on the part of the victim of Mack’s attempted rape and murder (Barry 1989, 734). If exposing Mack’s crime to the public is the limit of her “vengeance,” then Mack can count himself the most fortunate of felons.
2. The House ethics investigation of St Germain focused on benefits he received from the league and individual S&Ls. He, and female guests, dined routinely with a league lobbyist, who picked up the tab, and an S&L gave him an ownership interest in an investment (Day 1993, 257–258, 298–299).
After St Germain delivered a committee vote on April 1, 1987, in favor of a $5 billion FSLIC recap bill with forbearance, the House Ethics Committee voted on April 9 to issue a report that reads like an indictment of his ethics but ends with a free pass (Barry 1989, 213–214). The ethics committee arranged a further favor by holding the report’s release until the Easter recess to minimize publicity. The Speaker blocked Gingrich’s efforts to reopen the St Germain ethics inquiry (ibid., 542–543). The actions of the House Ethics Committee regarding St Germain were viewed as a whitewash even by Congress. Wright protected St Germain from censure.
3. Wright had met Dixon. Indeed, Wright had sent Dixon an autographed picture of the two of them together on Dixon’s yacht.
4. The league’s executive director, William O’Connell, explained:
Ironically, Treasury Under-secretary George Gould would say on January 21, 1987, that “given its organizational restraints,” that all the FSLIC could “efficiently use to resolve problem cases,” over three years was $15 billion, or $5 billion a year. Gould’s statement would be influential in the congressional debate (O’Connell 1992, 80n17).
1. Stan Parris (a Virginia Republican) should get at least an honorable mention. He fought to get the public to realize the depth of the S&L crisis.
2. Although Gonzalez was from a very politically safe district, opening himself up to the charge of betraying Texas was one of the few ways he could have lost an election. Moreover, he did not need to lose an election to be hurt. The Speaker had boundless ways to make Gonzalez’s life unpleasant.
3. Henry Gonzalez: Representative Gonzalez was the first Hispanic Texan elected to Congress. He was not a moderate, but he was so iconoclastic that he could appear moderate because his positions did not track a consistent partisan or ideological path. He was a big man with a huge craggy face dominated by a magnificent nose.
Gonzalez and Wright had similar backgrounds. Both were boxers who prized being tough. Both were populist Texas Democrats. They were from the same generation. They were quick to anger. Gonzalez, well into his 60s, tried to fight a man who called him a communist. They both loved to talk, and they were old-time populist orators who mixed an odd combination of folksy anecdotes, obscure references to Roman and Greek political philosophers, and ornate language into a political version of a religious revival meeting. By the mid-1980s, both men’s orations had begun to grate on many of their colleagues. “Henry B,” as he was called, was a lawyer and former math teacher (Day 1993, 317).
Gonzalez was seventy years old and had tremendous seniority. He was consistent about many things, especially championing civil rights and populist causes. Many of his colleagues thought he was a bit loopy. Those who liked him saw him as a modern Don Quixote de la Mancha, tilting at windmills and trying to save the oppressed. The ones who did not like him just thought he had a screw loose.
Gonzalez was patient and persistent. He made a good ally and a painful opponent. He figures prominently in later chapters that discuss events after he became chairman of the House Banking Committee. He died recently, and his son now represents his district.
Thomas Carper: Thomas Carper was nothing like Wright or Gonzalez in style or temperament. He was a pilot who volunteered to serve three tours flying surveillance aircraft off the coast of Vietnam during the war. He received an MBA from the University of Delaware. Trim and incredibly calm, he comes across as reserved, thoughtful, and highly professional. He later became governor of Delaware, and in 2001 he was elected junior U.S. senator from that state.
Jim Leach: He was a champion wrestler in a state (Iowa) obsessed by wrestling. His undergraduate degree is from Princeton, his MA (Russian studies) is from Johns Hopkins, and he then did further graduate study at the (very liberal) London School of Economics in economics and Soviet studies. He was chairman of the (liberal Republican) Ripon Society for many years.
A smart-as-a-whip Midwesterner, Leach is a very nice, fair-minded guy with high moral principles. He despises those who abuse power and was a passionate opponent of the control frauds. He was by far the most helpful member when we were trying to deal with the forbearance provisions. He is the only one of the four still in the House.
Buddy Roemer: Charles “Buddy” Roemer was a bit like Carper. His MBA was from Harvard and he dressed like a refined banker. He later became governor of Louisiana. He was the latest in a long line of reform governors who lasted one term. (Folks from Louisiana can stand good government only in very small doses.) He had changed parties and run for reelection as a Republican. You can glean most of what you need to know about Louisiana politics from Roemer’s having finished a distant third against the neo-Nazi Klan leader David Duke and the crook Edwin Edwards. The race between Edwards and Duke produced the classic bumper sticker: “Vote for the Crook; It’s Important.”
4. I took extremely detailed notes of the April 9, 1987, meeting with the Keating Five that eventually led to the Senate ethics investigation. The complete text of my final notes can be found in the appendix to Inside Job by Pizzo, Fricker, and Muolo (1992, 2nd. ed.) and in U.S. House Banking Committee 1989, 2:745–773. Each of the nine participants at the meeting testified to the accuracy of the notes. The most sincere compliment came from Senator Glenn. He testified (U.S. Senate Committee 1991, 5:198) that he knew my notes were extraordinarily accurate because
even some of the phrasing I use and the way I say things were captured exactly—commas in the right places and the whole thing, exactly the way I would let it roll out at a meeting like that.
It may be busted syntax, it is mine and I recognize it when it occurs. [laughter]
Two senators were convinced that they must have been tape-recorded (U.S. Senate Committee 1991, 3:302).
5. FAS 5 required recognition of “contingent liabilities” only when they were “estimable and probable.” The control frauds abused this loose standard to avoid loss recognition. FAS 15 allowed firms to avoid recognizing currently their losses on TDRs. Even if an S&L foreclosed on the real estate pledged as collateral on a bad loan, it did not have to recognize the full market-value loss. Instead, GAAP permitted S&Ls to use “net realizable value” (NRV) to calculate the loss. This always caused losses to be underreported, but the distortion was particularly severe for federally insured depositories.
One estimates the market value of income-producing real estate by discounting back to present value the net cash flows over a lengthy time period (e.g., thirty years). The discount rate should reflect the risk of the particular investment being valued. The typical ADC loan by a control fraud would have borne an enormous market discount rate because the borrowers’ creditworthiness was so poor, the business plans so pathetic, and the real estate markets so glutted that default and huge losses were almost certain. An NRV, however, used a discount rate that had no relationship to the risk of the investment being valued. The discount rate used in an NRV for an S&L was the interest rate the S&L paid on federally insured deposits (e.g., 5 percent). The lower the discount rate, the higher the “value” of the asset. Using NRVs, therefore, seriously overstated the value of the real estate securing defaulting ADC loans and understated the FSLIC’s losses.
6. Sanford later served as cochairman of the Senate Ethics Committee investigation.
7. Grogan testified about the memorandum in the Senate ethics investigation of the Keating Five. The committee’s independent counsel, Mr. Bennett, is the questioner (U.S. Senate Committee 1991, 87–88).
[I]t was attached to an article where Black was publicly attacking Wright. It was a remarkable article that a federal bureaucrat would publicly, using his name, go on the record and attack the Speaker of the House. And what Keating’s point was that, good grief, if this guy has got the gumption to … (laughter) … to take on the Speaker of the House, you ought to have an ally in the Speaker of the House. And if you know anything about Capitol Hill, you ought to be able to go get some allies and take care of it.
Mr. Bennett: That was a great recovery, Mr. Grogan.
Witness: Thanks.
(Laughter.)
Mr. Bennett: You can strike that from the record also.
(Laughter.)
The bouts of laughter make sense if you understand that Grogan’s “great recovery” was substituting “gumption” for a male anatomical reference at the last moment. Grogan was one of Senator Glenn’s aides before he served Keating, and the Senate Ethics Committee treated him like he was a member of the club even when he was describing a vicious abuse of power. The committee thought it all quite humorous, which reveals a great deal about the committee.
8. The bill was nominally $10.8 billion, but $800 million of it was a bookkeeping scam to increase the reported net worth of the S&L industry by restoring the “secondary reserve” as an asset on their books. (The details are arcane, inane, and unnecessary.)
1. Two postscripts. The manager’s risky investments caused large new losses at Eurekea Federal. Wall decided Eureka needed to be sold with FSLIC assistance. The potential acquirer did not want to be bound by the MCP manager’s long-term contract, did not want his services, and did not want to pay his exorbitant salary. The FSLIC fired the MCP manager! But Wall had insisted that we put him on a long-term contract, so the manager successfully sued for breach of that contract. The FSLIC had to reimburse the S&L’s legal fees and pay a very large damage award to the MCP manager. I ended up being the soccer coach of a kid whose father was the MCP manager’s lawyer. The lawyer could not understand why the Bank Board had acted so stupidly at every turn throughout the matter, but he was happy because the legal fees had paid for a very nice BMW. The taxpayers, of course, bought it for him, courtesy of Wall.
2. I was wearing my “Just Say No to Washington” button and came over to explain what had happened. At the end of my tale he asked me if I had a copy of the button he could wear.
3. We called it the Blazing Saddles ploy after the scene where the black sheriff pretends to hold himself hostage to stop the credulous, racist white town-folks from attacking him. Mel Brooks would be astounded to know that this ploy worked in real life.
4. I do not remember this attorney’s name; Mike and I remain thankful that he turned us around.
5. In the course of this, I said that a congressman could ask Wall, “Jesus Christ! What purpose could this letter have other than preventing disclosure?” Wall shot back, “There is no reason to invoke the deity in this discussion!” There followed about ten seconds of shocked silence while we looked around the conference table in San Francisco with dawning horror. Wall had obviously heard much worse than “Jesus Christ” at least hourly in the Senate. It was clear that either he had seized the opportunity to slam me personally, or he hated me so much that he could not contain himself. Either way, if how he handled this matter was indicative of his policies, I was in trouble, the FHLBSF was in trouble, and the Bank Board might be in trouble. Wall and his staff attempted no substantive defense of his position. As noted in Binstein and Bowden (1993, 299), “Thereafter, whenever Black is on the phone during a conference call with the staff in San Francisco, Wall will turn to his aides and mumble, ‘Why did they put this asshole on?’”
6. American Savings borrowed money through Reverse Repurchase Obligations (REPOs), which though structured as “sales,” are actually short-term loans invested in mortgage-backed securities, which are long-term, fixed-rate assets.
7. The Bank Board took two useful lessons from all this. It unwound American Savings’ interest-rate gamble, and it renewed efforts to sell the S&L. The Bank Board excluded the FHLBSF from the effort to sell the S&L and chose Bob Bass as the acquirer. Bass is one of the famous “Bass brothers” who have made fortunes investing in corporations and in Texas real estate. This set up a future long-running controversy with the FHLBSF, which (when it was finally permitted to see the deal) pointed out severe problems with the agreement that exposed the FSLIC to enormous losses. The American Savings fiasco did not cure Wall’s belief in silver bullets, and the miracle meant that there was no longer any reason to be nice to the FHLBSF. (A postscript: In late 1994 Orange County, California, became bankrupt. It had invested its funds in long-term bonds. Its investment fund grew rapidly by borrowing through short-term REPOs. Interest rates increased, producing a liquidity crisis. Orange County was not saved by a miracle. It lost $1.7 billion from interest-rate risk. Robert Citron, the disgraced treasurer, resigned, and the county replaced him with—Popejoy! [Jorion, 1995: 159–160])
8. Grogan had received Keating’s order to “Get Black … kill him dead.”
9. It would take too long to explain the series of obstacles the Bank Board put in the way of my retaining counsel, which led to my having to represent myself for a time. I am grateful, as always, to Cirona and the FHLBSF for displaying loyalty and preventing a travesty.
10. A September 26, 1986, Sidley & Austin memorandum suggests a plan to have many S&Ls bring dozens of Bivens lawsuits as “an offensive weapon” in order to paralyze the Bank Board. A Pierson, Ball & Dowd memorandum dated October 19, 1987, notes that they have hired a private investigative firm to investigate a carefully unidentified “subject,” which Grogan testified was me. Keating spent tens of millions of dollars each year on lawyers and deliberately set them in competition with one another to find which firm was willing to be the most aggressive. Kaye, Scholer won this competition.
11. The rest of the letter is equally amusing. Martin led Wall’s effort to understate greatly the cost of resolving the S&L debacle. The Bank Board mandated that the field offices use a methodology that would seriously understate losses. (Jim Barth provided them with five possible ways to estimate the losses; Wall chose the one that produced the lowest estimate.) The FHLBSF provided the number using the mandated methodology, but explained that it would seriously understate actual losses. The Bank Board criticized us heavily for that aspect of our response. Martin now cited our absurdly low estimate of losses—which he and Wall had mandated—as evidence of Patriarca’s ineptness.
12. When we finally learned of the letter, we assumed it was unprecedented. We learned subsequently that Stewart had provided a least one similar letter over the FHLB-Chicago’s opposition to an S&L it considered to be the victim of insider fraud. If Wall and Martin wanted the side letter issued, they should have shouldered the responsibility, not placed it on Stewart.
13. Luke’s cautious nature became clearer when the ERC finally voted to approve a subpoena for Saratoga Savings. I told him that the Bank Board had taken six months to approve a routine matter that used to be handled in a week and that Saratoga’s losses had grown steadily during the delay. He said, “But Bill, they threatened to sue us!”
1. On a personal note, I appreciated the irony of these same Lincoln Savings lawyers successfully demanding that the Bank Board exclude me from meetings that they would attend.
2. Tax-sharing agreements are normally a routine means of reducing the cost of tax compliance. The parent company and its subsidiaries file a consolidated tax return for the overall entity, and the companies agree to pay their respective shares of the total taxes. Lincoln Savings and ACC, of course, routinely turned the routine into another opportunity for fraud, and the tax-sharing agreement was no exception. In this case, they defrauded the FHLBSF (and through it, the public). For obvious reasons, an S&L or a bank is not allowed to make loans to its parent holding company. In the tax-sharing context, this means that the S&L cannot send cash to the parent for taxes that are not currently payable to the IRS. Lincoln Savings had large net-operating-loss carryforwards, so it was able to offset current income and greatly reduce its taxes. ACC/Lincoln Savings submitted a draft tax-sharing agreement that would have required Lincoln Savings, whenever it earned profits, to upstream cash to the parent company in order to pay taxes that were not currently payable (and might never be payable). The FHLBSF analysts reviewed it and informed ACC/Lincoln Savings that the provision was unacceptable for these reasons. ACC/Lincoln Savings replied that the agreement had been redrafted, and this provision removed, in response to the FHLBSF’s concerns. In fact, ACC/Lincoln Savings had substituted tax jargon that permitted the very payments the transmittal letter assured the FHLBSF had been prohibited by the revisions. ACC’s deception succeeded: the FHLBSF analysts did not understand that the tax jargon would have the opposite effect of the one purported. (The language was not run by the legal department, so my predecessor did not review it.) The Resolution Trust Corporation (RTC), the FSLIC’s successor agency, later filed suit against ACC on the grounds that these false representations constituted fraud.
3. Kennedy’s speechwriters apparently invented the quotation. Dante’s Divine Comedy does place neutral angels in Hell, perpetually harried by insects and chasing banners of authority.
4. Similarly, the Bank Board waited until after the election to close Silverado Savings, in which the vice president’s son Neil had played such a disreputable role (Wilmsen 1991, 182–183). Bank Board economists also informed a group of us at the FHLBSF that the newest projections on the need for, and cost of, a federal bailout of the FSLIC were complete but would not be released until after the election.
5. The Bank Board’s acquiescence in Keating’s tactic of branding as criminals those who blew the whistle on his misconduct turned the world upside down. Bank Board leaders tolerated the defrauding of widows in order to avoid embarrassing themselves and the Republican Party. That was morally acceptable to Wall, a man who carried a Bible next to his heart every workday. Exposing the fraud, and thereby protecting the widows, was the great evil.
6. Dixon pulled the same stall at Vernon Savings.
7. Arthur Young resigned as ACC’s auditor when Keating ordered Janet Vincent (Jack Atchison’s replacement as Lincoln Savings’ audit partner) to do something explicitly prohibited by the accounting rules. She refused, and Keating demanded that Young fire her. By this time, Young knew that both Lincoln Savings and ACC were hopelessly insolvent and that Atchison had exposed the firm to enormous liability. It wanted out, and seized the opportunity to resign. Peat, Marwick promptly and eagerly sought to replace Young. Peat, Marwick, however, also knew that it might be stepping into a minefield. The new auditor decided to disclose publicly ACC’s aggressive accounting practices and to seek the SEC’s prior blessing for the particular accounting treatment that had led Young to resign. (The SEC’s chief accountant listened to the new auditor’s lengthy pitch for recognizing income from a particular transaction. His decision: “No recognition.” End of meeting, end of Keating’s control over Lincoln Savings.)
Similarly, Peat, Marwick explained the accounting scam underlying the proposed acquisition of Lincoln Savings. The buyer (the Trump Group—not related to Donald Trump) and Lincoln Savings would both overpay (by over $40 million) to purchase a subsidiary from each other. Lincoln Savings would pay cash; the Trump Group would give a note (an IOU). In short, Lincoln Savings was financing the entire “purchase.” Peat, Marwick then issued the most unusual accounting opinion any of us had ever seen. In its opinion, these mirror purchases should be treated as independent, but if the Bank Board disagreed, the accounting opinion was automatically withdrawn.
8. It would require a far longer book to explain all the harm that befell the nation from September 1988 to late April 1989 when the Bank Board indisputably knew it was dealing with a massive fraud but took no effective action against it. In addition to the losses to those who bought ACC’s worthless junk bonds and the enormous new losses to the taxpayers from the new fraudulent investments, the Bank Board gave Keating’s lieutenants time to destroy documents and transfer surviving documents out of Lincoln Savings’ offices. Similarly, virtually all of Lincoln Savings’ (few) valuable assets were transferred to subsidiaries or pledged as collateral. ACC and Lincoln’s subsidiaries then filed for bankruptcy just before the California law changed and the CDSL would have taken over Lincoln Savings. The Bank Board, despite protests from Barabolak and warnings from the FHLBSF, took no action to prevent these subterfuges or to prepare to deal with the voluntary bankruptcy strategy. By filing voluntary Chapter 11 bankruptcy petitions, Keating hoped to stay in control of ACC, Lincoln’s subsidiaries, and Lincoln’s assets. (The law imposes an automatic stay that bars creditors like the FSLIC from retrieving looted assets without special permission of the bankruptcy court.) The FHLBSF, fortunately, had hired private counsel in Phoenix.
The Bank Board finally placed Lincoln Savings in conservatorship the day after the bankruptcy filings. The conservator discovered that virtually all of Lincoln’s valuable assets had been transferred to subsidiaries or sold. Lincoln Savings had no cash to stem the run. The Federal Reserve had to make unsecured loans to Lincoln Savings (U.S. House Banking Committee 1989, 1:15–16). Wall’s lieutenants got to explain to the vice chairman of the Federal Reserve how the Bank Board, knowing that it was dealing with the worst S&L fraud of all time, had allowed Keating to loot Lincoln Savings and put the Fed in this position. The vice chairman excoriated them. I was one of the FHLBSF personnel who heard the tirade on the conference line.
9. Which led to one of the great typos of all time. We received in our San Francisco office a trade journal with the following address label: “Office of Theft Supervision.” Too true.
10. The Keating Five and Senator Garn, however, would have found confirmation hearings for Wall acutely embarrassing. Riegle chaired Senate Banking, which would have had to conduct the hearings; Cranston was the most senior majority member of the committee; and Garn was the ranking minority member.
11. This was our Henry V moment. The French, losing the battle of Agincourt, violate the rules of war by slaughtering the English boys in the baggage trains. Henry announces that he has not been angry since entering France, but this barbarity enrages him (act 4, scene 7).
12. I had complained to O’Connell about a provision of the MOU; he said that I must not have the final MOU because he had had the same concern and had insisted the provision be changed. I went over to the Litigation Division, which was producing documents that Gonzalez had subpoenaed, and requested a copy of the final agreements. The MOU turned out to be identical to the copy we had; O’Connell’s memory was in error (a rare event). But the package also had the side letter. The side letter convinced us that we were dealing with a corrupt system that needed to be rooted out.
13. Jim Murphy, a partner at Squire, Sanders & Dempsey (the firm I had come from), met with Seidman shortly before this testimony to pitch him for some business. Murphy mentioned that I had been with the firm. Seidman responded, “I’ve never met him, but I know of him. He’s the kind of guy they should put in charge of OTS. [pause] Of course, it will never happen.”
14. It was ironic, after all of the odes sung by the ERC, Wall, and Martin on the necessity of remaining objective and nonaggressive to witnesses, that they responded to criticism so intemperately.
15. All of the FHLBSF’s senior leadership that dealt with Keating happened to be openly heterosexual.
1. For his book Maestro (2000), Bob Woodward interviewed Greenspan about the February 13, 1985, letter that contained this assertion.
Greenspan believed he would do it the same way again, given the information he had in 1985. When he reviewed Keating’s balance sheets, he found them both quite impressive and fiscally sound. Keating had not done anything wrong at that point, or if he had it wasn’t detectable. (66)
He wrote in support of Keating’s application to make four times as many direct investments as other S&Ls were permitted. The memorandum that I wrote recommending denial (U.S. House Banking Committee 1989, 2:370–386) used information that Greenspan could have obtained from public sources or his client. A comparison of his letter and my memorandum demonstrates four things: Lincoln had done many things wrong at the time Greenspan wrote his letter; if he had investigated the financial statements, he could have detected a great deal; Keating’s balance sheets were facially unsound and unimpressive; his other conclusions about the high quality of Lincoln Savings’ managers were untenable.
2. All of the examples Akerlof uses in his article are control frauds in which the object is to defraud the customer instead of creditors and shareholders. The S&L control frauds and the ongoing wave of control frauds generally targeted creditors and shareholders. However, modern control frauds often target customers, e.g., Enron and its coconspirators created and exploited the California power “crisis”; mutual funds widely abused customers; Tenet Healthcare allegedly practiced unnecessary surgery at one hospital, leading to the death of several patients, and fraudulently overbilled government health insurance programs; and, earlier, Koch Industries committed fraud against small oil producers.
3. Loss of financial trust was not a major problem during the S&L debacle because of deposit insurance. S&L creditors were almost entirely made up of insured depositors. They trusted the FSLIC, not the S&L. The FSLIC never lost that trust because the public was convinced that no president or Congress would permit the FSLIC to default (no political entity that did so could have survived). All the private funds that insured Ohio, Maryland, and Utah thrifts, by contrast, collapsed when depositors lost their trust.
4. Good advice, when talking about normal regulators. O’Connell reacted that way; Dochow, Stewart, Wall, and Martin, did not.
5. Andersen’s resignation should have been a red flag about Keating. Instead he threatened to sue the firm, which then changed its resignation letter into an attack on the FHBLSF. Keating used the Andersen letter to help recruit the Keating Five.
6. I may have some culpability for helping prompt this movement, for as the Bank Board’s litigation director I began suing the Big 8 accounting firms.
7. Black (2003, 22–40). Judges, especially appellate judges, have the unique advantage of being able to declare in court opinions that their theories are correct. Judge Easterbrook used this advantage to rule that a plaintiff would not be permitted to attempt to prove that an auditor was liable because it would be “irrational” for an auditor to do anything that would make him liable. Of course, a theory that cannot be falsified is not a theory, but dogma. Auditors, in fact, commonly give clean opinions to control frauds that are massively insolvent. Auditors, in fact, help control frauds create fictional income and hide real losses. Auditors do this primarily for rational reasons: because control frauds pay them enormous nonaudit fees and because of agency problems (the interests of the audit partner who is under severe pressure to bring in lucrative clients or be fired frequently diverge from the interests of the firm). But auditors also act in ways that Judge Easterbrook may consider “irrational.” An article by my colleague Robert Prentice (2000) skewers the claim that auditors would never aid a control fraud.
8. DeConcini, a former prosecutor, was barking at Patriarca, trying to intimidate him. He used the most inflammatory language he could (“prostitute themselves”) as a shutdown line, trying to force Patriarca to back down. Instead, Patriarca hit him square between the eyes: “Absolutely, it happens all the time.” DeConcini was visibly stunned. I do not think he had ever met a bureaucrat like Patriarca.
9. Conflicts of interest mattered on the federal regulatory side. The FHLBs clearly had potential conflicts of interest because they were owned by the S&Ls in their districts, and the president of each bank was also the principal supervisory agent. Cirona insisted on hiring senior officers with strong backbones and great integrity precisely because of this potential conflict. If an S&L CEO who was also on the board of directors of the FHLBSF indicated to our examiners that they best not push too hard, Cirona wanted to be sure that the response would be instant. The next morning, an expanded crew of our best and toughest examiners would enter the S&L like avenging angels, and Patriarca would personally call the CEO and read him the riot act. This was not, however, the case in all district banks at all times. The 1989 legislation removing the examination and supervision roles from the FHLBs was desirable. Similarly, the FHLBSF had stringent conflict-of-interest rules. We could not even get a home mortgage on demonstrably normal market terms from an S&L.
10. One-year ACC sub debt was issued at 9.50 percent interest on March 29, 1988, when the prime rate that banks charged healthy companies was 8.50 percent (U.S. House Banking Committee 1989, 4:255).