Fear descended on the cozy corporate boardrooms of the business world. Suddenly, anyone backed by Drexel was capable of buying all but the very largest companies, and when they did, they would often jettison management, lay off employees, and cut costs ruthlessly.
Many CEOs had little or no stock ownership in their companies, and Drexel derided them as complacent bureaucrats who hadn’t managed these companies in shareholders’ best interests. Often, Drexel had a valid point since a disconcertingly large number of companies had high expenses, underperforming divisions, and a stock price below the value that could be obtained if the company were broken up and sold in pieces.
Drexel became by far the largest practitioner of this strategy, and because the result was extraordinary profits, its competitors soon joined the fray. This is a core dynamic of a financial crisis: other lenders rush to imitate and keep pace with success.
Many in Congress and the public feared that these hostile takeovers were not just targeting poorly managed companies but good ones as well, with disruptive and undesirable societal consequences. But Drexel had invested considerable time wining, dining, and lining the campaign coffers of various politicians, so the junk-bond industry was well protected in 1984 when congressional concern inspired efforts to curb the use of junk bonds in takeovers and buyouts. Of thirty such bills introduced in 1984 and 1985, none passed. In fact, under the laissez-faire Reagan administration, both the Securities and Exchange Commission (SEC) and the president’s Council of Economic Advisers expressed support for takeovers. The Reagan administration even effectively blocked the Fed’s attempt to apply its margin limitation of 50 percent to LBOs—the very same margin limitation that had been put in place as protection from overleverage after the crash of 1929.
As the competition for LBOs increased, prices paid for companies rose, making the resulting junk bonds junkier. The junk-bond market soon reached Minsky’s Ponzi level—financing deals where the loan could never be repaid from cash flow and could only be repaid if the target company were resold at a higher price. A great example of this excess was Canadian real estate company Campeau Corporation’s flawed acquisitions of two large American department-store chains: Allied in 1986 and Federated in 1988. Campeau paid exorbitant prices for these companies, all gladly financed by the LBO lending industry, and then staggered under the weight of its junk debt. It was soon engulfed in bankruptcy, which caused an overall decline of the department-store sector.
Fraud and chicanery multiplied apace with activity in the LBO space. Illegal activities included insider trading, stock parking, preferential investment offers for a given firm’s employees than for its customers, bribery for special treatment in transactions, higher than allowable markups, fraud against clients, and more. Fraud doesn’t cause the boom or the crisis. It just feeds on unwitting participants.
The long prelude to the 1987 stock market crash had already begun with the decade’s runaway private lending. This lending was happening across the economy—in commercial real estate, the mania for LBOs, S&Ls, and two other crises, both predicated on lending: the Latin American debt crisis, which primarily affected large New York banks, and the crisis caused by the drop in oil prices, which primarily affected Texas and Oklahoma banks.
The increase in oil prices had hit many Latin American countries hard. The U.S. money-center banks, primarily based in New York, viewed this as a lending opportunity. They could finance these countries’ shortfalls by “recycling” the burgeoning deposits of oil-rich countries. In other words, they would lend the rapidly accumulating deposits of oil-exporting countries to the suddenly cash-starved oil-importing countries. This demonstrated exceptionally poor credit judgment by those banks, but it was rationalized by Citibank chair Walter Wriston’s pronouncement in the 1970s that “countries never go bankrupt,”22 though many had obviously defaulted on debt, and on many occasions.
At the end of 1970, the total outstanding debt of these countries was $29 billion,23 but it mushroomed to $327 billion by 1982,24 at which point the nine largest U.S. money-center banks had Latin American debt totaling 176 percent of their capital and total “lesser developed country” debt totaling 290 percent.25 The Federal Reserve’s marked increase in interest rates in 1979 only exacerbated these countries’ struggle to remain current on their debts.
The crisis came in the summer of 1982, when “less-developed countries” around the world, including sixteen Latin American countries and eleven elsewhere, were forced to reschedule their debts.26 Restructuring created its own problems. Banks abruptly and completely cut off new funding to these countries and tried to collect on the debt, which brought instant recessions in many places. In response, the Fed exercised its convening powers, bringing together lenders, central bankers, and the International Monetary Fund (IMF). This resulted in the usual cocktail of austerity, with government layoffs and cuts in health and education, along with a dose of new IMF funding to help countries make “interest-only” payments on their debts.
Notably, the Fed gave these U.S. money-center banks forbearance in recognizing losses from these loans. Most likely, they would have taken the more draconian step of shutting them down if they were much smaller banks, so this was one more approach to the now-familiar “too big to fail” dynamic. Without this forbearance, the net worth of these banks—America’s largest and most notable banks—would have been wiped out, and they would have failed.
After five years of this forbearance, these Latin American debtor nations were still not in a position to repay most of the loans, but the forbearance had done its trick. The U.S. banks’ earnings in that five-year period had finally put them in position to create reserves against these losses. Citibank led the pack in 1987 by announcing a then-shocking $3.3 billion loss provision, roughly 30 percent of its exposure from loans to less-developed countries, and other U.S. banks quickly followed Citibank’s example.27 Many of these debtor nations were still not in a position to repay their loans in 1989. So Treasury secretary Nicholas Brady took the initiative for widespread debt forgiveness and restructuring in exchange for continued domestic reforms in these countries. In all, eighteen nations signed on to the Brady plan, and roughly a third, or $61 billion, of the debt in question was forgiven.28
Next came the energy lending crisis. In the oil drilling that had followed Carter’s and then Reagan’s deregulation of domestic prices, Texas bankers mistakenly believed that oil prices would stay high. In fact, oilmen and their lenders quickly came to believe that oil was a scarce resource being inexorably depleted, and therefore prices could only climb.
An early, signature energy lending catastrophe was the 1984 FDIC takeover of the insolvent Continental Illinois Bank in Chicago, which would stand as the United States largest such takeover until the Great Recession. This came at a point when the price per barrel of oil had already dropped from its 1980 peak of almost forty dollars to less than thirty dollars, and had stemmed largely from energy loans Continental had purchased from Penn Square Bank of Oklahoma. Penn Square had made wildly excessive and, in some cases, fraudulent loans to the oil industry and itself had failed in 1982. Continental was one of the first banks to be called “too big to fail,” as regulators prevented losses on even its uninsured deposits. Critics pointed to this as giving rise to moral hazard and increasing the risk-taking that characterized the rest of the decade.
At a point when oil was still slightly more than thirty dollars per barrel, sober industry analysis forecasted near-term prices rising as high as ninety or a hundred dollars a barrel, though that level was not attained for another twenty years. Instead, in the spring of 1986, because of debt-financed over-drilling and higher production, the price per barrel plunged from thirty to eleven dollars.29 The major Texas banks had been heavy lenders to the oil industry, and with this fall in prices, every one of them failed, except for Texas Commerce, which had preemptively rescued itself by merging with New York’s Chemical Bank in advance of the worst industry news. They had simply made far too many oi
l-industry loans, along with far too many commercial real estate loans that depended on the demand brought by the oil boom.
With these crises simultaneously weakening the industry, bank failures erupted: 2,304 banks failed or needed assistance from 1986 to 1992. The FDIC had to step in at an ultimate cost of $36.3 billion, which was in addition to the eventual $160.1 billion in losses in the S&L industry.30
This was a disproportionately regional failure centered in the Southwest, the site of so many of the nation’s oil fields. Of the 2,304 bank failures, 40 percent happened in Texas and Oklahoma alone, even though their combined GDP was only 8 percent of the U.S. total.
As for S&Ls, in 1983, 10 percent were still technically insolvent and 35 percent were still losing money.31 Nevertheless, newly empowered owners kept the pedal to the metal, with forty Texas thrifts tripling in size over the next few years and California thrifts doing much the same. At the same time, Congress was parsimonious in its funding of regulators, so the FHLBB staff of examiners was actually shrinking at just the point these thrifts were tripling in size: a guaranteed formula for disaster.
Edwin Gray came in as the new FHLBB chair, understandably concerned about lax lending, and began reversing some of the previous regulatory laxity. He raised the net worth requirement for S&Ls to 7 percent.32 But he was blocked by Congress when he tried to eliminate deposit insurance for brokered deposits33 and restrict CRE lending. Politicians who were beneficiaries of the S&L industry’s campaign contribution largesse were the key agents of this obstruction.
Figure 2.6. Texas and Oklahoma Commercial Bank Failures, 1980–1994
Lending institutions can engage in foot-dragging and obfuscate the deterioration in the credit quality of a loan for months and even years, especially with an inattentive or accommodating regulator. This is especially true in commercial loans, which require subjective judgments about borrowers’ prospects. A loan that is troubled may not show up as such in a bank’s or an S&L’s financial statements for a year or two, or even more.
The tone in Washington began to change with the March 1984 failure of Empire Savings of Mesquite, Texas, which cost taxpayers $300 million.34 The New York Times reported that Empire Savings had grown by $240 million in assets in the first eleven months of 1983. They had used “questionable lending practices” and “artificially inflated” real estate appraisals to achieve this gain. The bank board charged that “the excess of the loan amount over the real value of the property was used to cover all loan fees” paid to Empire “and to pay an incentive bonus to borrowers just for signing the loan papers.”35
The Empire Savings CEO, Spencer Blain, who later was ordered to forfeit $22 million and serve five years on probation for his role in Empire’s practices, had purchased 60 percent of the institution’s stock and had a stellar industry pedigree. But Blain was ensnared by the siren song of easy riches, using depositor money to pay himself huge bonuses, not to mention bonuses and fees from Blain-managed real estate projects financed by Empire. It was a conflict of interest replicated on a massive scale at other institutions. It would include such names as Charles Keating, D. L. “Danny” Faulkner, Don R. Dixon, and Edwin T. “Fast Eddie” McBirney III, who were aided by naïve elected officials in resisting intervening regulators.
S&L failures were just beginning. Empire Savings was a harbinger of the decade’s crises, not its climax. In January 1985, the FHLBB finally was allowed to cap brokered deposits at 5 percent of deposits at S&Ls with insufficient net worth and put limits on direct investments, such as equities.36 But with continued failures, such as a new rash in Ohio and Maryland, the FHLBB simply didn’t have enough FSLIC funds to cover depositor losses.37 It had less than $5 billion for losses that it now believed could exceed $20 billion.38 Eventually, these losses would reach $160 billion.39
Unable to fund outright closure of troubled S&Ls, the FHLBB was forced into allowing many to remain open in the hope they could grow their way out of trouble. They couldn’t. By January 1987, the FSLIC fund was finally deemed insolvent, but lawmakers were still unable to face up to the sheer dollar size of the problem. This, coupled with pressure from S&L lobbyists critical of “overly harsh” regulators, meant that a sufficiently robust industry recapitalization was not yet in the cards.40
In May 1987, the FHLBB began phasing out much of the remaining accounting legerdemain,41 but that process would take two more years. In August, Congress partially faced up to the overwhelming cost of the problem by passing the Competitive Equality Banking Act of 1987, which added $10.8 billion to the FSLIC, but with only $3.75 billion authorized for any twelve-month period.42 The act also contained forbearance measures designed to postpone or prevent S&L closures.43
Much of the trouble came from Texas S&Ls, reeling after 1986 because of the oil price collapse—which they felt indirectly through their CRE loans. Congress’s inability to fund the full cost of the problem at this moment simply meant that it would drag on and snowball, therefore costing even more in the final reckoning. This phase of denial or delusion is typical of many financial crises. Regulators limped along with their limited funds and disposed of 205 S&Ls with $101 billion44 in assets.45
The most dramatic failure of the S&L debacle would come a few years later with Charles Keating’s notorious Lincoln Federal Savings and Loan, though hundreds of failures occurred even after this point. Lincoln was seized in April 1989 and cost the government over $3 billion, while leaving about 23,000 customers with worthless Lincoln Federal bonds. Keating had once urged his staff to “remember the weak, meek and ignorant are always good targets.”46 Once he took over Lincoln in 1984, Keating jettisoned existing, conservative management and grew Lincoln from $1.1 billion to $5.5 billion in five short years by lending and by buying land, buying equity in commercial real estate development projects, and buying Drexel-sponsored junk bonds.
Keating, like others in this era, made risky investments and used Lincoln as a personal piggybank. Lincoln exceeded its statutory limits in direct investment—limits that were designed to cap risk—by $600 million, but chafed when the FHLBB began to investigate this and other practices. He enlisted the help of five U.S. senators—Donald Riegle (D-MI), Dennis DeConcini (D-AZ), Alan Cranston (D-CA), John Glenn (D-OH), and John McCain (R-AZ)—along with Speaker of the House Jim Wright (D-TX) to protect him from the FHLBB in 1987. Keating also hired Alan Greenspan as a lobbyist “to help recruit the Keating Five.”47
Though the beleaguered FHLBB chair Gray did not succumb to that pressure, he soon left the agency, and his successor Danny Wall did succumb, allowing Lincoln to misbehave for almost two more years, thus increasing the cost of that institution’s failure. In 1992, Keating was convicted of various crimes related to his management of Lincoln and served four-and-a-half years in prison. Ironically, the government’s early 1980s deregulation of the S&L industry, especially in granting that industry new lending powers to help it earn its way out of trouble, led to rampant, ill-advised lending in the mid-1980s. This resulted in the late 1980s and early 1990s in eight hundred S&L failures, almost five thousand insolvent or inadequately capitalized S&Ls, and the need for $160 billion in rescue dollars.
Deregulation—or more accurately, changes in regulation—have figured prominently in many crises beyond this S&L crisis. For example, the British legislation that enabled the creation of joint stock companies in 1824 contributed to the 1825 crisis. Changes in laws and regulation in lending are always occurring in a given country, and business and lending communities are always engaged in an effort to “deregulate” to enable more, different, and expanded types of lending. Growth is the sine qua non of business and lending its means.
Enabling legislation does not predestine a crisis, and many crises have happened without it. Furthermore, industry can usually innovate its way around prohibitions. The test is whether, and how much, that deregulation facilitates riskier credit.
After a crisis, laws and regulations about lending often do need to be changed, but it is generally tru
e that much postcrisis legislation, including the 2002 Sarbanes-Oxley Act, which arose after the Worldcom and Enron debacles, and the 2010 Dodd-Frank Act, which came after the Great Recession, looks backward. It is designed to prevent the crisis that just happened and cannot foresee the form that the next crisis will take. These two acts contain items that were helpful and just as much that was burdensome and unnecessary. When regulations such as these are passed, the industry then quickly tries to reverse or evade many of the provisions and often succeeds. This tug-of-war will always be with us and always has been.
It should be noted that the banking industry committed sins similar to those of the S&L industry, at very hefty volumes and without as much deregulation. Further, the United Kingdom experienced a similar banking crisis in this period with different regulatory modifications. Even so, regulatory changes were central to large-scale S&L losses that otherwise would not have occurred.
The October 19, 1987, stock market crash, which became known as Black Monday, came in the wake of these LBO, banking, and S&L trends. For five years, starting in 1982, the stock market took off, responding positively to plummeting interest rates and the higher values implied by the expanding LBO volume. By 1987, the trailing twelve-month price-to-earnings of the S&P 500 had nosed past 20, far higher than the desultory 5 to 10 price-to-earnings level of the mid- to late 1970s (though not inordinately high by either current or historical standards).
But the Dow plunged 23 percent on Black Monday—worse than any one-day loss in the 1929 stock market crash, the September 11 terror attacks, or the 2008 financial crisis. Its own rise had been fed by margin debt, which had increased from $25 billion in 1980 to a record high $57 billion in 1986. This brought an end to a five-year bull market.
A Brief History of Doom Page 8