Interview
Michael Lea Discusses Failed Thrifts, Failed Policies
Michael J. Lea is a financial consultant institutions, for which the promised credit In many respects, yes. FIRREA changed
in San Diego. He served on the Cornell enhancement turned out to be inadequate. the rules of the game, forcing the sudden
University faculty after completing a In retrospect, Imperial was too thinly cap- liquidation of risky assets in thin mar-
PhD at the University of North Carolina italized given its risky assets, although it kets. In addition, thrifts were expected to
in 1978. Lea later was the Federal Home was in compliance with all regulatory re- raise additional capital at the same time
Loan Mortgage Corporation’s Chief quirements until the passage of FIRREA. that their earnings potential was reduced,
Economist. In 1987 he joined other The RTC took control of Imperial in an impossible task even in good markets.
FHLMC officials in assuming leadership February 1990, after the Office of Thrift The issue is the degree to which thrifts
of Imperial Savings in San Diego. Lea Supervision (OTS) rejected our capital are empowered to pursue profitable strat-
served as the institution’s Treasurer and plan. We felt that we had been taking the egies. The rules obviously have changed
Senior Vice President for Finance & proper steps. Our focus had been on under FIRREA. The 1989 law was de-
Capital Markets. When Imperial was tak- downsizing; we sold $2 billion in assets signed to do two things: first, to provide
en over by the Resolution Trust Corpora- during the last six months of 1989. the mechanism and funding for cleaning
tion in 1990 he remained to assist RTC up the thrift mess and getting rid of in-
in liquidating the institution’s assets. Did the RTC’s action come as a surprise? solvent institutions; second, to strengthen
Lea currently is working with fellow No; Imperial and the regulators were well the surviving institutions so that a similar
economist Douglas Diamond on an aware of the market value of the institu- crisis could not occur again. Based on
analysis of European housing finance for tion. In fact, two years prior to the issu- what has happened to date, I feel that
the Federal National Mortgage Associa- ance of Bulletin TB13 we were meeting FIRREA did a poor job on both counts.
tion. In the following interview, ORER the requirements that the OTS imposes In some respects it has been a step back-
LETTER discusses with Lea the downfall today. Imperial did a full mark-to-market wards, because it largely restricts thrifts
of Imperial Savings and the state of the under different interest rate scenarios and to lending in a mortgage market charac-
housing finance industry. provided the results to OTS; they regu- terized by excess capacity and low profit
larly received our quarterly figures and expectations.
How did the former Senior Vice Presi- therefore knew the market values of the
dent of one of the largest failed S&Ls institution’s assets. Our capital plans took And also characterized by a duration
end up working for RTC? The RTC into account expected losses, including matching problem. That is definitely
felt that my background with Imperial our forecast that more than half of our true historically, and the problem is not
would help in dealing with problems auto loan portfolio would default. We necessarily eliminated with adjustable
faced by the agency. My working showed that despite those expected losses rate loans, as many people have learned.
relationship with our regulators in San there was reasonable expectation that The future of the industry is in jeopardy
Francisco had always been good; I think over five years we would meet the capital if institutions cannot attract investors
they viewed Imperial’s management as standards and show positive earnings. so they can strengthen their capital posi-
having been forthright with them. I also But OTS felt it was too risky to allow Im- tions and compete as viable financial
think they recognized that Imperial had perial to remain under private ownership. intermediaries. Thrifts have to compete
significant talent that could help in sell- An important issue is whether the against banks, but a bank can do every-
ing assets and in running the organiza- values determined by a mark-to-market thing a thrift can do and much more.
tion until it could be sold. process should be used by regulators in Historically, thrifts received special tax
Before problems had set in, Imperial deciding whether an institution should benefits, and they had relative advantag-
was a highly visible institution, one of be closed; in Imperial’s case, there likely es over banks on the liability side of the
the ten largest thrifts in the nation, and were both overstatement and understate- balance sheet. Now the tax advantages
it enjoyed a reputation as an innovator. ment problems. For example, marked-to- are gone and, relative to banks, thrifts
Like many other S&Ls it was bankrupted market values of thinly traded assets that face asset disadvantages and have no
by the interest rate environment of the we held might have overstated prices that liability advantages. Therefore, a thrift
early 1980s, and it tried to grow out of could have been received in real transac- charter has no value.
negative earnings and capital positions tions, particularly if huge portfolios were As a consequence, no one is willing
with high-yield investments. Imperial to be liquidated instantaneously. On the to put new capital into marginal thrifts.
actually did fairly well in this endeavor, other hand, relying on marked-to-market One reason is the questionable value of
except in two areas. One was the junk asset values ignores the intrinsic fran- a charter. A second reason is uncertainty
bond market, which was devastated by chise value of a going concern. with regard to what the regulations will
both the closing of Drexel and the trou- be. The notion that legislators and
bled economy. The second was automo- Did FIRREA cause Imperial’s demise? regulators can change the rules might
bile loans purchased from other financial
page 10 ORER Letter Fall 1991
Interview
be called “sovereign risk;” the attendant ing effect. It reduced returns and encour- that controls more than $200 billion in
danger applies to banks and thrifts alike. aged equity investors to divest their hold- assets and 400 sites nationwide. Con-
If a sudden and massive change in the ings. The timing was not right; tax reform gress gave RTC an impossible job to do,
rules can wipe out your investment, then came at a time when the market was and then created impediments for them
you will require a much larger risk pre- characterized by overbuilding, which in to contend with in attempting to do that
mium. An extreme case occurred when turn was spurred by an excess supply of job. Examples of those impediments
the Federal Home Loan Bank Board insured savings deposits. include restrictions that the RTC not dis-
(FHLBB) permitted capital maintenance I believe that a major cause of the thrift turb distressed markets and that it hold
plans in order to get new capital into the problem was the large increase in insured back certain types of assets for afforda-
industry, but then a year later the new deposit limits that took place at the same ble housing groups. These laudable
OTS refused to honor the plans that had time that the technology to broker money objectives are inconsistent with the
been negotiated and refused to return the across the country was developed. Bro- goal of speedy resolutions.
money of those who had put up the new kered deposits are not themselves a cause
capital. of the thrift problem, but they are a symp- So the problem is not that there were
tom of what went wrong. Through depos- terrible management mistakes? There
So when you talk about sovereign risk it brokering, huge sums of money were have been management mistakes, but
you’re really talking about 5th and 14th funneled into truly marginal development these may have followed from RTC’s
Amendment issues, the taking of property
without compensation or due process.
Yes, directly in some cases and indirect-
ly in others. A change in the rules can Thrifts face asset disadvantages and have no
significantly affect the expected income liability advantages. Therefore, a thrift charter
stream from an investment. FIRREA crip-
pled the thrift industry in many ways. has no value.
One is that weak institutions can’t get
the capital necessary to survive, so a vast
number of thrifts will be taken over by projects. Even in the best of times a lot of conception and the impediments we just
the RTC; 600 already have been taken the real estate loans and direct real estate discussed. The agency has picked up its
over, and another 300 are slated to go. investments made by depository institu- pace in resolutions. From its inception
That number represents about a third tions offer marginal expected returns. through July of this year, RTC resolved
of the institutions in the industry, with Add a recession and a glut of properties 467 of the 633 institutions it had taken
in excess of $700 billion in assets. on the market, and marginal projects over. However, in order to complete
That $700 billion is supposed to re- become huge losers. these resolutions, it has had to retain
flect market values that will accrue to the most of the problem assets; through July
government. Of course, that point brings What kind of job is the RTC doing in sell- of 1991 only 47% of the assets of failed
us back to the question of true liquida- ing the assets of the institutions it has tak- institutions had been sold, transferred, or
tion values versus ongoing intrinsic en over? The agency had a very slow repaid. And the majority of asset reduc-
values. If they try to cram $700 billion pace of institution sales in the first nine tions have involved securities, so RTC
in assets down the gullet of the capital months of its existence, and while the has been left with a huge portfolio of
markets all at once, they’ll be lucky to pace has since accelerated, the results loans, real estate, and other assets.
get $400 billion. It’s a supply and de- are not what had been expected. Many Two of the major problems that the
mand phenomenon. There is a large sup- of the problems result from the way RTC has faced in marketing assets are
ply of assets of some types, such as com- the organization was created. Congress largely beyond the agency’s control.
mercial and multi-family loans, but there had such a poor relationship with, and so First, the recession and the credit crunch
is little demand for these assets, partially little trust in, the FHLBB that it decided to have greatly reduced the demand for any
because surviving financial institutions shut the agency down. It then created a assets other than government-guaranteed
are also trying to sell assets of this nature whole new bureaucracy, most of which is securities. Second, FIRREA reduced the
or will not provide funding for third par- staffed by the FDIC, to take over the Bank demand for thrifts by emasculating the
ty purchasers. Many institutions, Imperi- Board’s duties and run the failed thrift thrift charter; nobody wants to buy a
al among them, have large portfolios of institutions. So for political reasons whole institution (the assets and liabili-
performing loans for sale, but the market we created one of the world’s largest ties), so the only reason anyone is inter-
has all but disappeared. financial institutions overnight; it is not ested in a thrift is for its deposits, branch
surprising that this institution has been network, and customer base.
Did the Tax Reform Act of 1986 have an fraught with problems.
impact? Tax reform had an exacerbat- We are talking about an institution What is salable? Other than securities,
Fall 1991 ORER Letter page 11
Interview
the most attractive assets are the branch in return for assuming the liabilities is off high rate debt. So the government’s
systems and mortgage loan servicing reduced by the value of assets, typically cost of carrying assets is higher than it
operations. Unfortunately, the values of mortgage loans, received in the transac- should be, and the time it takes to sell
these assets depreciate rapidly after an tion; the buyer in effect purchases the institutions and/or assets is longer than
RTC takeover. For example, it took more loans. Because the deposits often carry it should be. As a result, the franchise
than one year for the RTC to sell Imperi- above-market rates, buyers demand cash values of acquired institutions are dimin-
al’s branch network and servicing portfo- to pay off customers who will withdraw ished. The premium that buyers would
lio. During this time, the association’s de- funds as soon as rates are lowered to mar- pay for deposits and mortgage loan ser-
posit and loan balances declined, and the ket levels. In addition, buyers demand, vicing erodes the longer RTC holds them.
market for these assets became saturated. and RTC provides, “putback” provisions
Great American, also based in San Diego, for all loans purchased. If the buyer can- Does this strategy represent speculation
sold its California branch network to not sell the assets for a price greater than about future asset values? No; it re-
Wells Fargo at the beginning of 1990 for the RTC’s selling price within a given flects the reality of what is salable in to-
a premium in excess of 5%. A year later period of time (usually 180 days), then day’s economic and credit environment.
the RTC sold Imperial’s branch network the buyer can put the assets back to RTC. But there are other ways of dealing with
for a premium of less than 1%. the assets. For example, RTC can try to
In the context of recent S&L sales, a What is the alternative? The RTC must sell whole institutions, the way FSLIC
did, rather than just selling deposits. The
FSLIC deals had some real merit to them;
It is a wash from the standpoint of the federal balance they facilitated the transfer of entire asset
sheet if insured deposits are paid off with new T-Bills; portfolios back to the private sector, with
the use of incentives such as yield main-
government-guaranteed debt is not increased. But tax tenance for the purchasers.
money is saved to the extent of the interest rate differential. Under yield maintenance arrangements
the regulator agrees to provide a spread
over the buyer’s cost of funds to compen-
“premium” means a discount in terms of recognize that it is in the long-term asset sate for negative earnings on the least
the liabilities assumed. A buyer that takes management business, and it must pursue attractive elements of the portfolio. The
on retail deposits in excess of the value the goal of maximizing long-term values. amount of incentive can vary deal by
of assets received must be compensated The first step that it should take is to find deal, but in every case the amount of
for agreeing to repay those excess liabili- the cheapest funding for the assets it yield maintenance is reduced over time.
ties. In the simplest case the RTC would holds. Doing so typically will involve This reduction provides the buyer with
give the buyer cash in an amount equal substituting Treasury borrowing for high incentives to manage the less attractive
to those net liabilities. But if the buyer rate deposit liabilities. If government assets properly so they eventually can be
valued gaining access to the failed insti- owns the assets, then government has resold. Selling whole institutions can be a
tution’s customer base, then it might pay to finance those assets. It is a wash from better value for the taxpayer than selling
a 2% premium; it would receive $98 mil- the standpoint of the federal balance assets piece by piece.
lion for agreeing to repay $100 million sheet if insured deposits are paid off with
more to depositors than it receives in new T-Bills; the supply of government- You favor private sector management.
cash or assets. The $2 million difference guaranteed debt is not increased. But Why can’t the public sector do the job?
is a premium paid by the buyer for access taxpayer money is saved to the extent The issue is one of incentives. We want
to that customer network. of the interest rate differential. the assets in the hands of people who are
Because thrift asset values have been Yet RTC is not doing that, because of motivated to manage them rationally.
battered, however, RTC has found it very another constraint on its activities. Con- Managers of thrift assets should have in-
difficult to get buyers to take anything gress didn’t want to fully recognize the centives to maintain the properties and to
other than deposits. So about half of cost of the S&L crisis, so FIRREA initially get the best value for the taxpayers upon
the resolutions to date have been either provided only $50 billion for RTC’s reso- sale. These goals cannot easily be accom-
“liquidations,” in which depositors are lution efforts, and Congress has not been plished in the public sector, which does
directly repaid, or “insured deposit trans- particularly forthcoming with additional not provide proper incentives.
fers,” in which deposits are transferred to funds. The government’s own estimates Let’s say that the taxpayers own a
other depository institutions, along with placed the total cost of resolution at $100 property. Should more money be invest-
cash. The rest of the resolutions have billion, $250 billion taking into account ed? Should it be sold today or a year
been “purchase and assumption” transac- expected interest payments over time. from now? The correct answer will vary
tions. These are the cases in which the The result of the underfunding has been based on the asset or the market. A pub-
amount of cash received by the buyer delay in selling institutions and in paying lic sector manager might be motivated
page 12 ORER Letter Fall 1991
Interview ORER News
by the agency’s budget constraint or by a The RTC continually is being second (continued from page 7)
desire to minimize his own potential for guessed. It was created by a vindictive New ORER Papers Available
headaches. The private sector provides Congress that itself was to blame for Several additions have been made
proper incentives for individuals who creating the mess but wanted to point the to the ORER Working Paper Series.
make such decisions. The owners of pri- finger at somebody else. RTC was set up Papers # 87, “Intermediation as a
vate organizations can share upside gains in an environment in which regulators Coordinating Mechanism,” and #88,
with managers through performance were lambasted before Congress for their “Market Makers vs. Match-Makers,”
bonuses. The lack of incentives doesn’t actions, so it’s difficult for RTC people to both were written by Abdullah
mean that public sector managers won’t make decisions, or even to delegate deci- Yavas. Peter F. Colwell’s “Land
make correct decisions; they may do so sion making. Value Effects of Revenue-Neutral
for altruistic reasons, for example. But as For most types of assets RTC requires Property Tax Reform” is paper #89.
economists, we know that the incentives four layers of review before a sale can “The Economic Role of Foreclosure,”
are not right. be consummated. For example, Imperial by Charles M. Kahn and Abdullah
With regard to securities, the RTC has wanted to sell a Boeing 747 that it leased Yavas, is paper #90; an abbreviated
done a reasonably good job; the majority to a major airline. We had to first get the version appeared in the Spring 1991
of assets sold recently have been securi- transaction approved in the RTC’s sub- ORER Letter. The last of the recent
ties. They’re easy to value and relatively regional office in Costa Mesa, then in the working paper entries is “The Micro-
economic Foundations of Locational
Obsolescence,” by Peter F. Colwell
There should be a universal banking charter, a national and Joseph W. Trefzger.
intermediaries charter, which would give thrifts the same A single copy of any paper in the
working paper series is provided free
basic powers, capital requirements, and regulators as of charge to anyone who submits a
those that apply to banks. written or telephoned request to the
Office of Real Estate Research.
easy to auction off. Once a system was regional office in Denver, and then in the
in place to handle securities sales, they Articles Reprinted
national office in Washington. We also
“Career Stage and Job Performance
were able to bypass a lot of the impedi- had to have the transaction and docu-
of the Real Estate Salesperson,” by
ments of a tiered decision making struc- ments reviewed both through RTC and
James DeConinck and Don Johnson
ture. When it comes to non-security through an outside law firm. That process
(ORER Letter, Winter 1991), appears
sales, however, RTC has been schizo- took about six weeks, and in the mean-
in October 1991’s issue of Texas
phrenic. The attitude throughout the time the deal fell through; Imperial still
Realtor®. Peter Colwell’s series of
organization is to sell at any price, yet owns the aircraft. We had a good offer,
articles on Vacancy Management
it is afraid to sell because Congress but we couldn’t deliver because of the
(ORER Letter, Summer 1989 –
second-guesses RTC’s decisions. inefficient decision making structure.
Spring 1990) was reprinted in the
Since each decision is second guessed,
May/June 1991 Journal of Property
Doesn't “selling at any price” conflict all decision making funnels up to the top
Management. ORER is pleased that
with RTC’s mandate not to interfere with level in Washington. As a consequence,
these prominent industry publications
markets? It does. As I’ve stated, how- delay is legendary within the RTC. There
have chosen to share our articles with
ever, on one hand RTC has a mission, is no mechanism or incentive for local
their readers.
while on the other hand it faces some managers to make decisions or take
constraints that make it impossible to ac- responsibility. They get no rewards for
complish that mission. The most severe Busy Real Estate Faculty
doing so, and they don’t want to be con-
The 1991 Fall semester has been
constraint is to avoid interfering with the stantly overruled. So it’s easier to defer to
a busy period for the full-time real
markets. But the private sector knows the next guy up the ladder. Congress set
estate faculty members at the U of I.
what assets are out there, so I don’t think a precedent for dealing with regulators it
On November 13 ORER Director
the magnitude of asset sales causes sig- didn’t like in its treatment of Bank Board
Peter Colwell presented his critique
nificant uncertainty in the market. The officials. People on Capitol Hill left little
of a DuPage County property tax
uncertainty is caused by RTC’s manage- doubt that they would scrutinize every
study to the county’s Regional Plan-
ment of those assets. In a Journal of Fi- action the RTC takes.
ning Commission. On November 20
nance article last summer Ed Kane sug-
he presented a seminar entitled “A
gested that this constraint was a delaying How can we get our financial intermedi-
Potpourri of Real Estate Pedagogy”
tactic that allowed Congress to escape aries on the road back to health? I
to faculty at the University of
blame while placing the onus on RTC. have four major suggestions. First, there
Fall 1991 ORER Letter page 13
Interview
should be a universal banking charter, placing of high cost liabilities with Treas- few other visible evil-doers, but there is
a national intermediaries charter, which ury borrowing, and to place the entire little chance of serious thrift reform until
would give thrifts the same powers, capi- resolution process on budget. The notion the public realizes the culpability of Con-
tal requirements, and regulators as those that we can somehow keep the process gress. The industry is beset with structu-
that apply to banks. This action would off budget and hide it from the deficit is ral problems; the federal government
strengthen the thrifts’ position by elimi- ludicrous; it costs taxpayers real money. was the S&Ls’ creator and long-term
nating the need for the thrift charter. We Consider how another country has han- protector, but these institutions eventual-
would find it easier to attract investors dled this situation. Hungary has its own ly were thrown to the wolves by Con-
to marginal thrifts, and might expand the S&L crisis, different in form but similar gress. I agree with your statements, but
set of purchasers for failed institutions. in structure to ours. One large savings I think it’s highly unlikely that Congress
Second, we should seriously consider bank has been the country’s primary will admit blame. Furthermore, the US
alternative disposition strategies for mortgage lender. Like US home lenders, case is more complex than Hungary’s,
failed institutions and their assets. One it loaned on a mismatched basis; when because the benefits have been more
strategy that deserves a close look is the deregulation was instituted in the late diffuse. There are people with low rate
“good bank, bad bank” concept, which 1980s the fixed rate mortgage (FRM) rate FRMs issued in the 1970s, savers who re-
was used successfully by Mellon Bank. averaged 3% while the cost of funds had ceived high rates due to excessive growth
The idea is that a problem institution’s risen to 20%. According to World Bank in depository activity in the 1980s, and
the developers who built shopping cen-
ters that stand empty in Arizona. Certain-
ly a few evil-doers may have benefited.
Favors were sold to the elderly through the deregulation Benefits have been distributed widely,
of interest rates on deposits in the Õ70s, and by the however, while the focal point for bear-
ing the cost will have to be the taxpayer.
expansion of the deposit insurance system in the Õ80s. But explaining the S&L crisis to the
taxpayer is difficult, and the issue is
complicated by the nature of our political
deposits, branch facilities, and earning housing finance specialist Bob Buckley, system. Congress dispenses favors the
assets are sold prior to a regulatory take- the drain on Hungary’s economy has benefits of which are highly specific, but
over in order to eliminate delays that been about 3% of gross domestic product. the costs of which are paid by tax dollars.
erode the franchise value. The premium The government has put the associated Favors go to those who make campaign
generated by the sale of the good bank losses on its own balance sheet and borne contributions, or to those who at least
provides capital for the bad bank. The the cost until inflation can be reduced. show support at the polls. Favors were
managers of the bad bank therefore have The Hungarian government has admitted sold to the elderly through the deregula-
upside potential; their goal becomes that the low FRM rates benefited borrow- tion of interest rates on deposits in the
proper management in order to maximize ers and that the country now must raise ’70s, and by the expansion of the deposit
liquidation values. taxes or cut services in order to pay for insurance system in the ’80s. These
My third suggestion is that we try to those benefits. This approach has generat- actions also curried the favor of home
learn from the 1988 FSLIC deals. Those ed much discussion about who really buyers by expanding mortgage credit at
resolutions were far from perfect; there should pay, since it’s clear who the bene- below-market rates, and curried the favor
were tax benefit giveaways and some ficiaries were. Yet while the Hungarian of generous campaign donors in the real
clear cases of undervaluation in light of government has explicitly recognized the estate and S&L communities.
the risks retained by the taxpayers. Those cost, our Congress has never explicitly The recent Keating Five hearings
losses are sunk costs; we can’t worry recognized that the US has a serious showed that the problem is more perva-
about them now. But the notion of selling problem and that the taxpayer is going sive than the S&L issue. It is interesting
whole institutions rather than pieces has to have to pay. that Senator Cranston defended himself
a lot of merit. If we can use creative by raising the broader question of how
approaches, such as yield maintenance I'm visualizing how your recommenda- our political system runs. The costs
combined with risk-sharing, then healthy tions would play in the media. Entrepren- associated with frequent reelection cam-
institutions will be interested in manag- eurs who took over thrifts would take a paigns force the people who make our
ing problem institutions’ assets, not just lot of heat; they’d be called “vultures,” most important policy decisions to solicit
in taking over their deposits. I am confi- and all of their actions would be second- huge contributions; a scenario like that
dent that we would find properly struc- guessed. It seems that the way to correct sets the stage for problems like the S&L
tured sales of whole institutions to be the problems is to force a public admis- mess. Some form of public campaign
more cost effective than selling pieces. sion of where the fault really lies. It has financing might be needed to remove the
Finally, we have to accelerate the re- become popular to blame Keating and a incentives for elected officials to be so
page 14 ORER Letter Fall 1991