Savings and Loans - The subprime crisis light

Savings and Loan crisis

Accounting control fraud

Accounting control fraud
The subprime crisis is about accounting control fraud, about senior executives engaging in extensive fraud for personal gain. It is about creating fictitious profits through grotesquely overvalued assets; it is about looting your firm through exorbitant salaries, fees, bonuses and other perks; it is about leaving the losses to clients and taxpayers.
Accounting control fraud is nothing new. It was behind the Savings and Loan (S&L) crisis. It was behind the Enron scandal. It was behind Bernie Madoff. As an introduction to the subprime crisis, this chapter will give a short description of the S&L crisis. It is based almost entirely on Bill Black's book The Best Way to Rob a Bank Is to Own One. If that's too much, there is also an excellent interview available where Bill Black compares the S&L crisis to the subprime crisis.

Savings and Loan Associations

Savings and Loan
A Savings and Loan association is a sort of small time bank, catering mostly to house owners, with most of the assets bound in fixed rate mortgages. At least that's how it once was. When basic interest rates were doubled in 1979, fixed rate mortgages lost in value and many S&Ls got into trouble. The S&L crisis started and by 1996 the Government Accountability Office estimated that the total cost was $370 billion, $341 billion taken from the taxpayers.

Hiding debt

Goodwill
With federal guarantees, the S&L crisis made a big hole in the federal budget. To hide this, the administration permitted different tricks. Like fictitious assets called "goodwill". A high risk get-rich-quick scheme called "risk-controlled arbitrage" was encouraged. Opportunistic entrepreneurs saw the possibilities to exploit troubled S&Ls by creating fictitious profits through overvalued assets. The more overvalued they were, the bigger was the real debt and the bigger was the goodwill; a goodwill that was a fictitious profit but booked as real. With the creation of those enormous fictitious profits, Federal Home Loan Bank Board chairman Richard Pratt saw the new entrepreneurs not only as brilliant, but also as people deserving thanks for making federal guarantee payments superfluous. Little did he know.

Creating fictitious profits
There were many tricks to create fictitious profits. Like daisy-chaining. Let us say that S&Ls A, B and C each buy land worth $5 million on the open market. Then A sells its land to B for $50m, B sells its land to C for $50m and C sells its land to A for $50m. The firms all make a fictitious profit of $45m and the personnel gets big bonuses. No examiner of A would find a link because in A's accounts they would be independent, likewise for B and C. $50m is seen as a correct value because that is what they got when they sold it.
Sometimes your accounts need an accommodating accounting firm. Sometimes the administration is accommodating. When the rules were changed to permit real estate instead of cash deposits, the fraudsters immediately saw the possibilities. They could say they wanted to do a $5 million deposit but they only had a real estate parcel with an appraised value of $20m. So they made a $20m deposit and got $15m back in cash. Maybe the real value of the parcel was only $2m.
The Treasury was very much aware that the S&Ls' financial statements were wrong, that many S&Ls were insolvent. Their conclusion was that because the statements were wrong but the firms were still functioning, they did not have to care about insolvency; the industry was sound and failed S&Ls should not be closed. If they could not meet their obligations they could grow. The administration encouraged insolvent S&Ls to engage in Ponzi schemes, using new deposits to pay interest on old deposits.

More help for the fraudsters
Accounting control fraud is not for the loner. First of all it takes accommodating attorneys, appraisers, accountants and auditors. Finding them is not difficult. Those who are not accommodating won't get the job so they soon learn to behave. Every control fraud was okayed by at least one "Big 8" accounting firm. To get help to loot the firms, lawyers were hired; when questioned, the looters say their lawyers told them it was OK. And it was accepted, without much reprisals for the firms or the lawyers.
Political support is also very valuable. With generous handouts, legal or illegal, it is easy to get. As "Mr. Clean", noted anti-pornography activist and fraudster Charles Keating said: "Did my financial support make political figures support me? I certainly hope so." Not that Keating paid everybody who supported him. Many were so eager to please him, there was no need to bribe them.
To please Keating, many prosecutors were transferred to prosecuting pornography. Relaxed rules about conflict-of-interest and net-worth requirements made things easier for the fraudsters. The Federal Home Loan Bank Board's (FHLBB's) deliberate cover-up of the S&L crisis also made it more difficult to prosecute for fraud; if fraud is federally embraced it will be difficult for a court to send a CEO to prison for fraud.
After the S&L crisis, lawsuits against the accounting industry were mounting and they faced a crisis of their own. They did not want to pay and formed a many-million lobbying coalition; in 1995 they managed to enforce a law making them immune to many lawsuits.

Lincoln Savings and Loan

Lincoln Savings and Loan: No foreseeable risk
In 1984, Keating took over the Lincoln S&L of Irvine, California. Like many others he broadened the assortment and started speculating in land, real estate and junk bonds. In 1985, the FHLBB was alarmed at the new activities. They made a rule that S&Ls could not put more than 10% of company assets in "direct investments".
Alan Greenspan, later to become Chairman of the Federal Reserve but at that time chairman of an economic consulting firm, protested. Quoting a study showing that S&Ls violating the rule earned higher profits, he claimed that Lincoln Savings "posed no foreseeable risk of loss". Within two years, all 33 companies in the study had failed. Although Greenspan's protests were rejected, Lincoln continued to violate the rule; they forged hundreds of signatures to make their deals look legitimate. Retirement communities were targeted, tens of thousands of California widows becoming victims when they got junk bonds for their life savings.

"make life unbearable for Gray"
Keating became legendary for his ability to manipulate politicians. He got widespread support from both administration and Congress, often by making more or less conspicuous gifts. Many within the administration saw Keating as a genius, a man with superhuman qualities. Even when they knew about the crash of Lincoln Savings, they thought Keating was the man to sort it out. Keating got support from among others Chief of Staff Donald Regan. He got support from a very aggressive Speaker of the House Jim Wright, and from five senators, later to become infamous as "the Keating Five".
The prime opposition to Keating's deregulation efforts and the prime target for his rancor was the FHLBB. Keating fought back, with lawsuits and threats of lawsuit, with detective investigations. He got his men into FHLBB, obstructing work and trying to take over. Especially targeted were FHLBB chairman Edwin Gray (successor to S&L friendly Pratt) and litigation director William Black (who was to write The Best Way to Rob a Bank Is to Own One). Keating worked to "make life unbearable for Gray", ceaselessly attacking him in different ways. He had private detectives investigating Black. He sued Black for $400 million. In a memo he even wrote "GET BLACK - KILL HIM DEAD" (he did not try to really follow it through).
Gray continued his regulation efforts. However, when his term as chairman of the FHLBB ended, he was replaced by Keating-friendly Danny Wall. One of Wall's first actions was to stop a pending investigation of Lincoln S&L. Investigations were barred and for the first time ever a cease and desist order was issued against an investigating agency.
Still, there were sufficient serious investigators left. At last Keating and his men went too far; when they tried to prevent the FHLBB from taking an enforcement action, it led to a Senate ethics investigation. Keating and many others were convicted of felonies.

Comparisons between the S&L and subprime crises

Similarities between S&L and subprime crises
In many ways, the S&L crisis is like the subprime crisis. A fictional profit made through absurdly overvalued assets and a hidden ever growing deficit. With fraudsters claiming higher understanding, claiming that regulators don't understand economics. Widespread admiration, almost worship, of the culprits, with a belief that only those who had caused the mess could fix it. With massive financial support from S&Ls to administration and Congress. With support, massive though not total, from within the Congress and from the administration. Many of those involved probably acting in good faith, not understanding that defrauding "yourself" can pay (in reality defrauding tax-payers, your clients and your firm).

Differences between S&L and subprime crises
There are differences between the S&L and the subprime crises. In the S&L crisis, personal attacks were very common. Regulators were accused of being Nazis, even of being sadistic homosexuals. They were accused of pursuing personal vendettas and political agendas. They were accused of going after Democrats. They were accused of going after Republicans. They were sued and threatened with jail. The subprime crisis is more silent, with culprits acting innocent and federal agencies just refusing to act.
In the S&L crisis, many S&Ls failed. In the subprime crisis, a few banks failed or were sold while many big banks were saved from failure by taxpayer money. In the S&L crisis, more than 1000 people were sentenced for felonies. In the subprime crisis it has only been some token small fry sentences. Instead, in the subprime crisis multibillion settlements have been imposed. A large part never paid, another large part paid by the victims. Fraudulent S&Ls were closed down, with big losses to individuals and to the taxpayers. In the subprime crisis, most losses are covered with client and taxpayer money. The culprits are still going strong, with illegal foreclosures and other illicit methods. Compared to the subprime crisis the S&L crisis was small, with small S&Ls growing out of proportion. In the subprime crises, the main culprits are many of the really big cats within finance.
The subprime crisis is a remake of the S&L crisis but on a larger scale, with fictional profits hiding growing debts. The administration's handling is a perfect illustration to that old saying: those who cannot remember the past are doomed to repeat it.

© Anders Floderus