If You Like Sheila Bair You'd Love Ed grey And Tim Ryan – Part One

This article was prompted by Joe Nocera’s July 9, 2011 “exit interview” with the FDIC Chair, Sheila Bair (“Sheila Bair’s Bank Shot“).

Reading Nocera’s interview caused me to recall Federal Home Loan Bank Board (Bank Board) Chairman Dick Pratt’s exit interview in 1983.

In 1983, I was a senior associate who was part of a team of outside counsel defending a challenge to the Bank Board’s appointment of a receiver for Biscayne Federal Savings. Pratt had been Chair when the agency put Biscayne into receivership. His successor, Ed grey, was Chair by the time the case came to trial. I was researching Pratt’s statements and actions to prepare the defence to the receivership challenge. I found that the Reagan administration had been so bizarre about receiverships that the Pratt Bank Board had become crazed on the issue.

I also found that the Pratt Bank Board had a soft spot for accounting scams. The Reagan administration’s paramount priority at all times during the savings and loan debacle was covering up the scale of the losses. Pratt adopted a series of accounting abuses designed to delay loss recognition for years and create fictional income and net worth. The Reagan administration knew, however, that receivership would require the recognition of massive losses. The Pratt Bank Board, therefore, refused to place failed S&Ls in receivership. Pratt inherited one legal challenge to the appointment of a receivership (Telegraph Savings) from his predecessor.

The Reagan administration was so obsessed with covering up the S&L losses that its Treasury spokesman testified to Congress that it would be “irrational” to appoint a receiver based on the insolvency of an S&L because a federally insured bank could always meet its liquidity needs by raising the rate it paid on deposits to ensure that it grew rapidly enough to meet any withdrawals. Yes, you understood his testimony correctly – the Reagan administration’s official position was that we should run the industry as a Ponzi scheme.

The same senior Treasury official then testified in support of Telegraph Savings’ legal challenge to the agency appointment of receiver on the basis of the S&L’s self-reported insolvency. In addition to all the obvious insanity of all of this it is worth emphasising that had Telegraph Savings won its case the Treasury would likely have had to pay damages to its shareholders. The court ruled that the statute expressly authorised the agency to place an insolvent S&L in receivership.

During this period the Bank Board “resolved” hundreds of failed S&Ls by merging them and using accounting scams to transmute the merged entity into an S&L that reported it was profitable and solvent. Typically, these deals were done with no federal financial assistance. By 1983, hundreds of these scam mergers had been done and the fictional accounting income and net worth were so large that they made a deeply insolvent and unprofitable industry appear profitable and solvent.

Biscayne’s dominant owner was Kaufman & Broad (the huge real estate developer). Biscayne was losing money in 1981 and 1982 due to interest rate risk and headed towards GAAP insolvency (on a market basis it had long been insolvent). The Pratt Bank Board and Biscayne decided that an accounting scam might greatly delay Biscayne’s insolvency. The idea was for Biscayne and the Federal Savings and Loan Insurance Corporation (FSLIC) to exchange notes.

The notes would have the same present value, but they would be structured to create a major difference in their face values. The FSLIC note would have a high face value but pay a very low interest rate while the Biscayne note would have a low face value but pay a very high interest rate. The goal was for Biscayne to book the difference in the face values of the notes as a “gain.” That would have created fictional income and net worth for Biscayne, but the Bank Board feared that the auditors would not agree to treat the fictional income as real.

By early 1983, Pratt concluded that his “resolutions” of hundreds of insolvent S&Ls had stabilised the industry and it was appropriate to begin to place GAAP insolvent S&Ls in receivership. Biscayne was the first major receivership. Thomas Vartanian, the Bank Board’s general counsel, however, was not a litigator. Despite the favourable Telegraph Savings ruling, the clear statutory authority to appoint a receiver for an insolvent S&L, and Biscayne’s admitted insolvency Vartanian worried that the court might rule against the agency. Vartanian was not a litigator and his concerns were not sensible.

The irony was that his suggestion as to how the agency could improve its litigation position that created the problem that he feared. Vartanian, in front of a number of Bank Board lawyers, including one who kept detailed notes, suggested that the agency could appoint a conservator on Monday “hope for a run” on Wednesday and use the run as the basis for appointing a receiver on Friday. Vartanian’s suggestion was immediately rejected by his colleagues, but the damage was done.

The trial judge decided (1) that the notes of Vartanian’s suggestions were not privileged and had to be turned over to Biscayne’s lawyers and (2) that Vartanian was a snake. He ruled that the Bank Board had acted in bad faith and declared the appointment of the receiver was improper. We were able to overturn the ruling on appeal.

All of this is background to my review of Pratt’s exit interview when I was preparing to help defend the Biscayne case. Pratt was almost uniformly viewed as a genius. He was an academic expert in finance. The Bank Board staff was amazed at how quick he was. The Reagan administration loved him. He was the architect of the Garn-St Germain deregulation law of 1982. (He based it on Texas’ deregulation law – the worst possible template.) He had come into an impossible situation – the mass insolvency of the S&L industry – and instilled a “can do” attitude among the dispirited staff. He had “resolved” hundreds of failed S&Ls at virtually no cost to the FSLIC. Only the S&L industry hated Pratt (because he made no effort to hide his disdain for the industry’s leaders).

My review of the Biscayne files gave me a tremendous advantage over those who were amazed at Pratt’s accomplishments, for I knew of the cynical proposed exchange of notes between Biscayne and FSLIC and Pratt’s willingness to create fictional accounting income to “resolve” problems. I knew that Pratt’s claims of success had to be false.

How could one merge two insolvent, unprofitable S&Ls and produce an S&L that was instantly solvent and profitable? Pratt’s claims were too good to be true and given what I had learned about his willingness to assist Biscayne in using accounting scams it was likely that accounting fictions explained Pratt’s claims that he had “resolved” hundreds of insolvent S&Ls through mergers. This insight into the madness in Pratt’s method was helpful in 1984 when I accepted the Bank Board’s request to become their litigation director.

Pratt made four primary points in his exit interview. He took credit for turning the industry around and putting it on the road to recovery through his minimal cost mergers of insolvent S&Ls. He argued that his deregulatory efforts had transformed the S&L industry by creating an entrepreneurial culture and attracting entrepreneurial managers. He expressed his severe disappointment that the Reagan administration had rejected his advice and chosen Ed grey as his successor.

He stressed that his recommendation had been Vartanian because of his intelligence and commitment to continuing Pratt’s policies. The reporter conducting the exit interview with Pratt was convinced of his unparalleled success and brilliance. She did not conduct a critical interview. Instead, she recorded Pratt taking a victory lap. Unlike Bair, Pratt was wrong about everything important. His mergers, deregulation, desupervision, and choice of senior staff combined to make the crisis far worse. Martin Mayer observed that if you had to pick one person most responsible for the second (accounting control fraud) phase of the S&L debacle it would be Dick Pratt.

The alert reader will find the regulator’s use of accounting scams and hidden tax and Fed subsidies to claim victory – which turns inevitably to disaster – familiar. Timothy Geithner is infamous for emulating Pratt’s one-two punch – use accounting scams to hide the losses and claim that your policies have “resolved” the crisis at virtually no cost. The second instalment will discuss how wrong Pratt proved to be about grey and show why those who (deservedly) praise Bair (and all financial regulators) should learn about and emulate grey’s successful policies.

grey was even more successful than Bair and he succeeded in an impossible environment. The second instalment will also demonstrate why Geithner’s claims that he resolved the ongoing crisis for far less than the costs of resolving the S&L debacle are absurd. grey’s and Timothy Ryan’s policies actually resolved the S&L crisis instead of emulating Pratt’s use of accounting scams to claim that he resolved a crisis at trivial cost. Geithner has not resolved the ongoing crisis, but he has sown the seeds for the next crisis.

Bill Black is the author of “The Best Way to Rob a Bank is to Own One” and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.