May 09, 2008 12:49 AM UTC

The S&L crisis and what it tells us about McCain

• 5 Comments
• by: Danny the Red (hair)

Warning this is long

Much has been written about the ethical implications of Senator McCain’s involvement in the Keating 5 scandal where McCain attempted to influence a federal regulator at the Federal Home Loan Bank Board to ease off on the investigation of Charles Keating’s Lincoln Savings & Loan.  

McCain received over $100K from sources connected to Keating and McCain’s wife and father-in-law had partnered with Keating in a real estate deal to the tune of nearly $500K and McCain used Keating’s jet on a series of trips around the country.  McCain even jetted to Keating’s private Bahamian Island of Cat Cay.  The behavior raised eyebrows, but Senate rules allowed the favors and Senate only censured McCain for questionable judgment.

However, this misses the point.  Whether you think using the private jet of a company under investigation is right or wrong, there is a broader policy question: what is your view of regulation.

In the late 70’s S&Ls (AKA thrifts) were in trouble.  High interest rates and the development of Money Market funds led to a drain on the low cost funds, such as savings account moneys, were replaced with higher cost funds purchased in the bank Jumbo CD market (loans between banks and other financial organizations).  Collapsing interest margins (difference between the interest lender get from loans minus interest paid to savings accounts or CD holders) ate away at bank capital weakening the systems foundations.  As capital shrunk, the amount of loans an S&L could make shrunk, since capital drives leverage.  To prevent technical insolvency many state regulators slashed minimum capital requirements from 5% to 3%, further weakening the Thrifts.

The solution, the Garn-St. Germain Depository Institutions Act of 1982, whose full title was “An Act to revitalize the housing industry by strengthening the financial stability of home mortgage lending institutions and ensuring the availability of home mortgage loans,” was a Reagan deregulation initiative.  Amongst the effects of the law, it allowed S&Ls to move into new types of business, including credit cards, commercial lending and taking the equity position in property speculation.

However, it left S&Ls under the regulatory umbrella of the sleepy backwater of the Federal Home Loan Bank Board or a hodgepodge of state regulators.  The regulators were wholly unprepared to evaluate the new risks the S&Ls could take.

Almost simultaneously, an “Oil Glut” caused large numbers of Texas Oilmen to look for ways to diversify their investments.  The beaten down thrifts were cheap and offered a brand new set of opportunities.  Oilmen were not the only people attracted by the Thrifts: the ability to take equity positions in real estate deals attracted property developers.  This brought in a new set of owners, far more aggressive than the old Thrift management and these new owners had friends in Washington.

4 years later, the Thrifts were in trouble: riskier loans, aggressive management, and an over reliance on high cost funding had placed the Thrifts in an unstable position.  As the Oil glut and mid trend bottoming of interest rates bit in 1986, real estate stumbled.  The regulators woke to reality, but the weak regulatory body did not have any support in an America defined by Reagan’s anti-regulatory mood.

John McCain simply reflected that mood.  When Thrift owner, property developer and friend called McCain, he got together with a group of senators who happily grilled the busybody regulator who had been making business tough for Keating.

Keating fought on, floated some junk bonds to elderly investors who thought they were buying FDIC insured paper, until finally in 1989 under the weight of rising interest rates, the Thrift collapsed into bankruptcy.  Keating remained unrepentant and fought for the next 10 years to defeat civil claims and criminal charges and finally in that great American tradition, wrote a book “The Best Way to Rob a Bank Is to Own One.”

When all the failures were added up, Bush’s brother Neil’s failure at Silverado and McCain’s friend Keating at Lincoln Savings and Loan amongst them, the total cost according to the GAO was $160 billon.  The economy slowed from the weakness in housing and finance and led to in part to the 90-91 recession.

Knowing the government had to take action to get the credit and real estate markets moving and develop a new regulatory architecture, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was passed.  Critics have attacked FIRREA as a bailout, and they are right.  The collapse of the S&Ls cost American taxpayers $125 billion in direct costs in order to stabilize and reenergize the economy.  Without the bailout the 90-91 recession would have been far worse.

What critics of FIRREA missed is that with proper regulation, the bailout would never have been necessary.  Moreover, this is why Charles Keating and Lincoln Savings and Loan are relevant to John McCain.  It is not the influence peddling or the Robin Leach lifestyle paid for by a convicted criminal: it is that McCain never learned the lesson of the S&L collapse-GOOD REGULATION SAVES TAXPAYERS MONEY.

Maybe later I’ll go through the financial deregulation of the late 90’s/00’s and explain how McCain’s views would, much as Hoover’s inaction, will lead to an economic collapse if our current crisis is not addressed.