August 2, 1989
"The S&L Bailout may be Just a Temporary Thing"
San Jose Mercury News
By Timothy Taylor
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EVEN at a cost of $306 billion over 33 years, the savings and loan bailout now agreed upon in the congressional conference committee is only a stopgap.

A useful stopgap, mind you. But one way or another, follow- up legislation will be needed. Unless the additional legislation attacks the structural problems that led to the collapse of the S&L industry, then this bailout may only be the first of a series.

The structural problem that got the S&Ls in trouble in the first place was their legal definition. S&Ls have traditionally been required by law to put most of their assets into residential mortgages, which made sense back in the days when high finance wasn't so high.

But new securities to raise money for mortgages have been created and sold in the 1980s. These new securities took a lot of business from the S&Ls.

Then, when interest rates shot sky-high at the end of the 1970s, S&Ls were stuck in a declining business, owning a lot of mortgage loans that paid low-interest rates. To compete with other financial institutions and attract deposits, they had to pay higher interest rates.

This combination was on its way to driving the industry into bankruptcy, until Congress stepped in and deregulated the S&Ls, giving them the freedom to compete in other lines of business. But the bailout legislation handcuffs the S&Ls all over again.

For example, one requirement is that S&Ls get back into the residential real estate business. Another requirement prohibits S&Ls from investing in high-risk bonds, also called "junk" bonds. But a sensible portfolio will always contain some risky assets; in fact, a portfolio of junk bonds has been quite a good investment for the past few years.

The S&L industry almost collapsed because it was too over- regulated to be adaptable. Now, in the name of saving the industry from itself, the bailout bill sets up the industry to be vulnerable all over again.

A second structural problem is that those running the S&Ls haven't had enough of their own assets at risk, which created a situation of perverse incentives. An S&L that faced bankruptcy had an incentive to make wildly risky investments. After all, if the S&L got lucky and the risks paid off, it would be out of financial trouble. If the high-risk strategy went bust -- which is what "high-risk" has a nasty tendency to mean -- then federal deposit insurance would pay off the depositors. After all, you can only go bankrupt once.

The bailout does try to address this problem by requiring that all S&Ls raise their "tangible capital" -- that is, the amount of money the S&L itself has at risk -- to 3 percent of total assets. Since about 80 percent of S&L assets are held by institutions with less than 3 percent tangible capital, this step is not negligible.

But the 3 percent solution is not particularly stringent either. The comparable standard for banks is 6 percent.

Also, the bailout legislation allows "goodwill" to account for half of the tangible capital of an S&L, at least until 1994. "Goodwill" is an accounting concept which puts a value on the fact that an existing S&L has a customer base and an established reputation. Whatever the (questionable) merits of "goodwill" as an accounting device, it's not cash on hand.

The slight increase in capital standards will help this problem of perverse incentives, but it is no solution. Whenever an S&L gets near the line where regulators will take over, it has an incentive to start taking higher risks.

The third structural problem for the S&L industry is that bank regulators haven't been able to step in quickly when an S& L starts down the dangerous road of high-risk loans, largely because congressmen from Jim Wright to Alan Cranston have viewed it as a "constituent service" to pressure and hinder and delay the S&L regulators on behalf of their local financial institutions.

Perhaps the most positive fact to come out of the S&L bailout is that defending a bankrupt S&L has become about as popular as defending a polluter against the Environmental Protection Agency. But S&Ls are a powerful special interest group everywhere in the country; they'll be back for favors when the glare of publicity dies down a bit. And I fear congressmen will be waiting with open wallets.

The S&L bailout does deserve some credit. It raises enough money that the bank regulators can start closing down the institutions that have been pushed or gambled themselves into bankruptcy. It makes sure that depositors in the bankrupt institutions don't lose their savings. It moves toward making S&Ls put more of their own assets on the line.

But in this summer of movie sequels, once around is never enough. If Congress and President Bush pass this bailout and sit back on their laurels, prepare for "Return of the S&L Crisis."

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