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Volume Title: Politics and Economics in the Eighties
Volume Author/Editor: Alberto Alesina and Geoffrey Carliner, editors
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-01280-8
Volume URL: http://www.nber.org/books/ales91-1
Conference Date: May 14-15, 1990
Publication Date: January 1991
Chapter Title: Political Foundations of the Thrift Debacle
Chapter Author: Thomas Romer, Barry R. Weingast Chapter URL: http://www.nber.org/chapters/c5418 Chapter pages in book: (p. 175 - 214) 6 Political Foundations of the Thrift Debacle Thomas Romer and Barry R. Weingast
6.1 Introduction The collapse of the U.S. savings and loan industry is one of the major economic developments of the 1980s.’ Current official estimates of the cost to American taxpayers of resolving failed thrift institutions exceed $300 billion over the coming decade. Some knowledgeable observers contend that even that figure is optimistically low.2 There has been a torrent of analysis of the thrift debacle. Much of this work has focused on the debacle’s economic underpinnings. These economic factors include the adverse interest-rate environment facing savings and loan (S&L) institutions at the beginning of the decade, particularly when coupled with the imbalance in maturities of S&L assets and liabilities. In mid-decade, the collapse of real estate markets in the oil patch and hard times in the farm belt had a devastating impact on S&Ls in those areas. Federal deposit insurance provided what has amounted to a government-backed guarantee that encouraged many thrift institutions to hold increasingly risky assets as their net worth declined. Low capital requirements further encouraged a type of risktaking behavior that has been characterized as “gambling for resurrection.” In a number of spectacular cases, outright fraud and theft have occurred.
The American thrift industry, like the financial services sector in general, Thomas Romer is professor of politics and public affairs at Princeton University. Barry R.
Weingast is senior fellow at the Hoover Institution, Stanford University.
The authors thank James Barth, Philip Bartholomew, Dan Brumbaugh, Dennis Epple, Allan Meltzer, and Kenneth Scott for helpful conversations or comments on an earlier draft. They are especially grateful to James Barth and Philip Bartholomew for their assistance in obtaining some data. Keith (“General Crunch”) Poole gave unstintingly of his time and expertise. Mike Caldwell, Paul Joyce, and Michael Loomis provided able research assistance. Partial research support was provided by the Center for the Study of Public Policy at Carnegie-Mellon University (Romer) and the National Science Foundation (Weingast).
Thomas Romer and Barry R. Weingast has been highly regulated for the last half-century. The events of the 1980s have called into question the effectiveness of the regulatory structure and performance. Many of those who have explored the economic aspects of the S&L crisis have at least alluded to regulatory failures. Though some have noted links to the political process generally and to congressional politics in particular (see, esp., Kane 1989a, 1989b, 1989c), there has been no systematic treatment of the political underpinnings of the crisis.
In this essay, we are concerned with documenting these political aspects of the thrift debacle by focusing on the role of elected officials. We contend that, although the industry did face severe economic shocks during the decade, political action-and inaction-played an important role in shaping the environment in which thrift institutions and regulators operated. The regulatory structure in place at the beginning of the decade was itself a political creation.
Its key elements-such as deposit insurance, portfolio restrictions, capital requirements, resources available to regulators-were politically determined.
Any changes in these elements in response to changing economic environments would also be subject to political forces.
Other writers have detailed the escalating costs associated with delay and regulatory forbearance in the face of mounting problems in the thrift industry during the second half of the decade (see, e.g., Brumbaugh and Carron 1987;
Brumbaugh 1988; Barth and Bradley 1988; Brumbaugh, Carron, and Litan 1989; Kane 1989a, 1989b, 1989c; Scott 1989a). We argue that Congress was the major source of regulatory forbearance during the crucial period 1985-87.
Our analytical perspective centers on the institutional structure of congressional decision making and on incentives faced by individual congressmen.
These incentives led to interventions by some legislators on behalf of constituents (individuals and thrift institutions) to urge regulatory relief. Systemwide, they also resulted in delay in recognizing the magnitude of the problems facing the Federal Savings and Loan Insurance Corporation (FSLIC). Conflicting interests across key committees of the House and Senate-under different party control during the first six years of the decade-also militated against timely, corrective legislation.
In 1981, 85% of the approximately 3,750 thrift institutions insured by the FSLIC had negative earnings (Barth and Bradley 1988). This was the worst of a series of increasingly unprofitable years for the industry. More significantly, the 1979-81 surge in interest rates had wiped out the industry’s net worth, as measured by current market value.3 Even by the more lenient standards of generally accepted accounting principles (GAAP), there was a marked deterioration in the financial health of thrift institution^.^ The FSLIC was faced by a record number of problem thrifts. The regulatory response was to merge or liquidate only some of the worst cases and to allow many insolvent thrifts to remain open.
The pattern of easing up on regulatory enforcement was codified in the 177 Political Foundations of the Thrift Debacle Garn-St Germain Depository Institutions Act passed by Congress in late
1982. This legislation had as its primary goal the partial deregulation of the financial sector. It expanded the scope of activities permitted to thrift institutions, and it broadened the type of assets that they could hold. It also relaxed regulatory accounting standards for thrift^.^ Over the next two years, as interest rates declined, it appeared to many observers that the crisis was over.6The number of thrifts that received direct or indirect FSLIC assistance fell (see table 6.1).
As is now well known, 1983 through early 1985 was just the calm before the storm. By late 1985, Edwin Gray, chairman of the Federal Home Loan Bank Board (FHLBB), testified before Congress that FSLIC would require $14-$15 billion in additional funds to handle newly emerging problems.
When Congress passed legislation nearly two years later, the magnitude of the thrift solvency crisis had grown to an estimated $50 billion. Yet the 1987 legislation provided only $10.8 billion in additional FSLIC funding, less than regulators had requested in 1985. The problems of the thrift industry continued to mushroom, so that by the time new legislation was once again considered in 1989, the scope of the liabilities facing FSLIC and American taxpayers had exploded to $200 billion.
In this essay, we focus on the issue of how the thrift problem of the mid-1980s transformed so quickly. It is widely recognized that a major factor in the magnitude of the problem has been the behavior of insolvent thrifts.
The structure of deposit insurance gave insolvent but open thrifts (what Edward Kane has called “zombie” institutions) strong incentives to undertake high-risk investments. If the investments turned sour (as many of them did), thrift owners had little or nothing to lose-the institution was already insolvent anyway. The additional losses would eventually have to be covered by FSLIC, whose ultimate guarantors were the taxpayers. If, on the other hand, the investment paid off, the thrift might be able to lift itself out of insolvency, with the positive returns going to the thrift’s owners. This systematic “gambling for resurrection” has meant that, except in the extremely unlikely event
Source: Brumbaugh (1988, table 3-2).
‘Includes other types of assistance cases.
Thomas Romer and Barry R. Weingast that most of the gambles were to pay off, the cost of the eventual resolution of the debacle would grow dramatically.
Gambling for resurrection may well have been largely responsible for the explosive growth of the thrift problem. But why was such gambling allowed?
Why did regulators not stop it? Given the rapid growth in the problem, why was Congress so slow to respond? Why was the 1987 legislation too little, too late?
Several hypotheses have emerged to address these questions. Some argue that the regulators were incompetent and failed to do their job. Had the FHLBB only been more attentive to what was going on in the industry, for example, it could have abated the crisis when it was much smaller. A second argument suggests that fraud by greedy thrifts hid the problem from view. A third explanation suggests that the thrifts, through intense lobbying and large campaign expenditures, were able to sway key congressmen to violate “ethical practices” by intervening in the regulatory process on behalf of the thrifts.’ Although each of these hypotheses is partially correct, they all miss the key element in the foundations of the thrift debacle. Massive gambling for resurrection was allowed to proceed because Congress intervened in the regulatory process to establish and enforce a policy of forbearance. This policy, initiated at the start of the decade, was later expanded in two ways. First, by delaying FSLIC recapitalization (partly by design and partly for other reasons, discussed below) and by keeping recapitalization to low levels, Congress ensured that regulators could force only some insolvent S&Ls to close or reorganize.
Second, the FHLBB was generally on the side of forbearance. When regulators did propose to embark on a tougher policy, Congress intervened to prevent enforcement of existing rules and, through new legislation, relaxed many regulatory provisions. Moreover, in many respects, Congressional behavior with respect to the thrift industry should be seen as fairly routine politics, rather than as an outrageous deviation. We emphasize the role of Congress over that of the president because the latter generally adopted a more passive stance, reinforcing rather than counterbalancing congressional initiatives favoring ailing thrifts. While the president in principle might have attempted to oppose a policy of forbearance, he did not do so.
Our thesis, then, is that the way Congress handled the emerging thrift crisis fits into a more general pattern of the way Congress responds to constituencies and to regulatory developments. Relatively routine behavior during 1985-87 generated both delay in legislation and the reinforcement of forbearance that allowed thrifts to gamble for resurrection.
To establish this thesis, we begin by summarizing a framework that encompasses the relationship between a regulatory agency and Congress and describes how bureaucratic policy choice comes systematically under congressional influence (sec. 6.2). We then shift to a more specific discussion of the regulatory environment of the thrift industry circa 1985 (sec. 6.3). This sets the stage for a somewhat detailed narrative of legislative responses to the 179 Political Foundations of the Thrift Debacle changing economic environment and the regulators’ proposals to deal with it (sec. 6.4). This narrative is useful, not primarily because it tells an intriguing story, but because it shows how legislative response fits into the framework we have outlined. As part of the discussion of the 1986-87 legislation, we provide some econometric evidence about the connection of constituent interests to congressional behavior. In section 6.5, we summarize our findings and draw some lessons we think are applicable to other potential debacles.