what did we know and when did we know it? gao's role in analysis of the savings and loan crisis

What Did We Know and When Did We Know It? GAO's Role in Analysis of the Savings andLoan CrisisAuthor(s): Teresa AndersonSource: PS: Political Science and Politics, Vol. 24, No. 3 (Sep., 1991), pp. 447-451Published by: American Political Science AssociationStable URL: http://www.jstor.org/stable/420087 .

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Kriz, Margaret E. 1989. "Hurry-Up Auc- tioneers." National Journal, October 7: 2457-61.

Moore, W. John. 1991. "First, Pay the Law-

yers." National Journal, April 27: 978-82. Starobin, Paul. 1990. "Taylor's Views on

Bailing Out Thrifts." National Journal, May 12: 1166.

About the Author Donald F. Kettl is professor in the Robert

M. La Follette Institute of Public Affairs at the University of Wisconsin, Madison. He is the author, most recently, of Deficit Politics.

What Did We Know

What Did We Know and When Did We Know It? GAO's Role in Analysis of the Savings and Loan Crisis* Teresa Anderson, U.S. General Accounting Office

As the taxpayers' bill for the cost of the savings and loan debacle continues to increase-recent estimates suggest total costs of about $500 billion-and the insurance fund for the nations' banks runs close to empty, many people are asking how and why we got here, and where is the accountability for such a disas- ter? What was the government doing while all of this was happening? While much has been written about who should be blamed and the lessons learned from this crisis, it is important for those of us in government to evaluate our contributions to the analysis of this issue and examine what we have learned.

As an evaluator of the General Accounting Office (GAO), Congress' "watchdog" agency, I will focus on GAO's evolving role in the analysis of the savings and loan crisis. GAO combines the expertise of accountants, economists, and analysts familiar with the internal operations of the federal agencies to provide a unique and comprehensive analysis of major policy issues. The S&L issue is a particularly useful case study for GAO because it illustrates the dramatic growth in our expertise and ability to contribute to policy analysis over the last decade. In 1980 GAO issued no reports relating to the thrift industry, while in 1989 GAO issued 28 reports and testimonies specifically about thrifts.

Overcoming the Learning Curve

GAO's primary function is to sup- port Congress by conducting audits that deal generally with the financial reporting of government activity, the

efficiency of program implementa- tion, and the evaluation of program results. Although GAO was established in 1921, it is a relative new- comer to issues relating to banks and savings and loan associations. GAO's audit authority over the federal financial regulatory agencies was limited to the review of financial statements until 1978 because these agencies did not operate from federal funds. In the mid-1970s some congressional committees, concerned about several large bank failures, re- quested GAO to study the supervisory activities of the bank regulatory agencies. Following the completion of GAO's study in 1976, Congress passed the Federal Banking Agency Audit Act in July 1978 (P.L. 95-320) which extended GAO's audit authority over the federal banking agencies.' In response to the legislation, GAO established the Federal Oversight of Financial Institutions Group within the General Government Division with 24 staff positions. Today this group is called the Financial Institu- tions and Markets Issues group and includes about 150 staff, some of whom are located in field offices or within groups dealing with related issues.

GAO's new financial group devoted its first few years to learning about the agencies and issues, focusing on traditional GAO audit areas relating to the efficiency and effec- tiveness of the agencies' programs, primarily their supervisory capacity. One of their first audits, which was completed in September 1981, focused on the supervision of the savings and loans.2 GAO concluded in this report that despite the increasing number of problem S&L institutions, the use of formal enforcement

actions by Federal Home Loan Bank Board supervisory personnel had decreased. This report identified problems with supervision and recommended that the formal supervisory process be strengthened. Later reports would focus more on the implications of the poor supervision.

GAO's next major thrift report, issued in 1983, focused on the Fed- eral Savings and Loan Insurance Corporation's (FSLIC) management of the savings and loan deposit insurance fund.3 This report discussed generally the dynamics of the industry, how the insurance fund had weathered the 1981-82 period of ris- ing interest rates and the consequent increases in the numbers of insolvent institutions (730 S&Ls were merged or liquidated during 1981 and 1982). It also suggested that the future of the FSLIC fund depended largely on interest rates and the effects of new competitive factors on industry prof- its. Later reports would further ana- lyze the impacts of industry develop- ments on the condition of the industry and the fund.

Developing a Strategy During 1983, GAO began imple-

menting a strategy for addressing the key S&L policy issues that were just coming into focus. First, GAO strengthened its financial and economic expertise by hiring some additional staff. Then the financial group developed a work plan that identified some of the major changes that were occurring within the financial services industry and the relevant issues for future work. The Comptroller Gen-

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The Savings and Loan Crisis

eral described the plan to Congress in a June hearing in which he stated that, "Before legislation can be designed to adequately deal with market changes, the first step is to identify what is happening in the financial services industry, why it is happening, and where things are headed."4 A major focus was on safety and soundness regulation: What type and mix of regulation and oversight is appropriate to assure adequate protections for depositors and investors? He committed GAO to providing the answers to these questions.

He also identified a second area of future work: addressing the short- comings of data on financial institutions. Not enough information was being gathered by regulators, and not all of what was being gathered could be effectively aggregated for industry-wide studies. The Federal Home Loan Bank Board (FHLBB) com- pletely revised the format and content of the semiannual Financial Statements submitted by all FSLIC- insured institutions and moved to a quarterly reporting schedule in March 1984. The result was that little historically consistent data could be obtained from published sources.

To overcome this obstacle, GAO decided to develop its own database. This task was assumed by a small specialized group of economists who worked with a private financial services consulting firm to develop a consistent set of thrift industry data based on information from the FHLBB financial statements for the period December 1977 to September 1984. The vehicle for accomplishing this task was a legislative mandate included in the Garn-St. Germain Act of 1982 which required GAO to examine the net worth certificate program. The report issued in Sep- tember 1985 provided GAO's first detailed analysis of the condition of the thrift industry. 5 The report described industry trends in asset growth and composition, net worth, and rates of return. It also noted the rapid growth that occurred from the end of 1982 to 1984 (the average annual rate was almost 20% for FSLIC-insured institutions) and described how thrifts had taken advantage of the new powers permitted in the 1980 and 1982 acts.

Another part of GAO's financial analysis work which also became more influential at about this time was its financial audits of FSLIC, the S&L's insurance fund. Heretofore GAO's legislatively required financial audits of FSLIC had generally been routine and succinct. However, in 1985 GAO issued a qualified opinion on FSLIC's 1984 financial statements because FSLIC had not allowed for losses from three large savings and loans that failed in 1984 with assets of $1.3 billion.' This began an on- going dispute between GAO and the FHLBB on the level of losses that should be recognized in the annual financial statements. The financial

In the fall of 1985 GAO first reported to the Congress that the thrift industry was facing serious problems that could severely impact the insurance fund.

auditors also began to include com- ments on the condition of the industry and its impact on the fund, and these analyses subsequently became a more substantial part of the annual financial audit reports.

Identifying Problems in the Industry

GAO's understanding of the depth of problems in the industry grew with the use of its newly developed database. In the fall of 1985 GAO first reported to the Congress that the thrift industry was facing serious problems that could severely impact the insurance fund. GAO's testimony alerted the Congress that the thrift industry's problems were not just related to interest rates but also reflected a serious asset quality problem.

This message was heightened and elaborated in a report issued in Feb- ruary 1986 which also questioned the level of demand that might be placed upon the FSLIC fund.7 This report

presented basic measures of the industry's net worth and return on assets using three accounting con- cepts: regulatory accounting principles (RAP), generally accepted accounting principles (GAAP), and tangible net worth (TAP). The report showed that about 15% of the industry (461 FSLIC-insured institutions) with about $113 billion in assets were GAAP-insolvent and another 26%, with assets of about $320 billion, were financially weak. The FHLBB's Chairman Gray responded that the report overstated the problems facing FSLIC, which could only serve to worsen the actual situation.

During 1986, GAO increased its warnings about the seriousness of the situation and the need for quick action. A report issued in September 1986 identified credit risk as another serious problem that could signifi- cantly increase the FSLIC cost of liquidating financially troubled institutions.8 GAO also testified before a House subcommittee on weaknesses in the accounting standards used by the regulators (RAP) which resulted in hidden losses and a significant understatement of the estimated resolution costs of failed institutions.' GAO continued its warnings in 1987 when it released two additional reports on FSLIC's forbearance policies and programs, such as the Man- agement Consignment Program, to assist troubled thrifts by augmenting their capital levels. The reports dem- onstrated that these programs had failed to restore many thrifts to a sound capital position and that if the institutions had been closed earlier, FSLIC's costs would have been reduced. 10

Estimating the Size of the Problem

During 1987, GAO concentrated on estimating the extent of the industry's losses and the amount of funding that FSLIC would need to resolve the continually increasing number of insolvent institutions. Early in 1987, GAO testified before the House Banking Committee and issued a companion report stating that preliminary results of FSLIC's 1986 financial audit indicated that the insurance fund had a negative net

448 PS: Political Science & Politics



What Did We Know

worth of more than $3 billion and urging quick and decisive action to recapitalize the fund. Several mem- bers of Congress had asked GAO to examine Treasury and FHLBB's $25 billion recapitalization plan. In response GAO constructed a model to simulate the plan's operations under a variety of assumptions about conditions in the economy and industry. GAO concluded that the recapitalization plan was workable for the problem institutions that were already recognized but that the amount of money might not be sufficient to address any additional problems that FSLIC might have to deal with in the future. The report also mentioned that FSLIC should re- examine its examination and supervision activities to prevent fraud or unduly risky industry practices, particularly in insolvent institutions. "

Following this testimony, GAO received a letter of strong protest from the U.S. League of Savings Institutions charging that GAO was frightening the Congress into passing Treasury's "bloated" FSLIC recapitalization plan. Their letter then commented on GAO's financial audit of FSLIC saying, "GAO does not conduct a true audit of the FSLIC."12 GAO often found itself at odds with League officials and with both FHLBB Chairman Edwin J. Gray and his successor, M. Danny Wall, over estimates of FSLIC losses and recapitalization needs.

GAO touched off another furor when it released its qualified opinion of FSLIC's 1986 financial statements in May 1987.13 The audit report stated that the fund had suffered an almost $11 billion net loss for 1986 and had a deficit of more than $6 billion. It further noted that FSLIC estimated that the ultimate cost of resolving about 380 troubled institutions might reach $25 billion and that the $5 billion recapitalization legislation under consideration by Congress would not be sufficient. In August 1987 Congress passed a $10.8 billion recapitalization bill which still proved insufficient to permit the FHLBB to close insolvent institutions.

GAO struggled further with the new FHLBB Chairman Wall over FSLIC's 1987 financial audit. Every month in early 1988 the FHLBB provided GAO with a new estimate of

the loss allowance, beginning with $2.5 billion in January and finally agreeing to $17.4 billion in May 1988. GAO issued a qualified opinion on FSLIC's 1987 financial statements in July 1988 and raised its estimates of the total cost of resolving troubled thrifts from $26.4 billion to $36.4 billion. 14 The U.S. League again protested GAO's audit figures and continued to understate the magnitude of the problem.

GAO testified before Congress in May 1988 on the results of its 1987 financial audit. This testimony was broader in scope than previous testimonies. It discussed the causes of the industry's problems, stating that, "Diversification into riskier activities,

GAO was now being asked to assist Congress in determining what should be done.

high cost of funds, and insufficient supervision, coupled with severe economic downturn in certain sectors of the economy, have left many thrifts with little except enormous losses from their poor quality assets." 15 GAO's testimony also discussed the condition of the industry and the fund, cautioned that FSLIC's reve- nue projections were optimistic and warned Congress that further congressional action might be needed to obtain adequate funding.

GAO continued to tell Congress throughout 1988 that FSLIC did not have the resources to resolve the S&L crisis and that FSLIC was "running up the bill" with future promises to pay while industry losses continued to grow. As the number of insolvent institutions increased, so did GAO's estimates of the costs for resolving them.

Developing Solutions to the Problem

During 1989, GAO's focus shifted to finding solutions for the thrift

industry problems. GAO was now being asked to assist Congress in determining what should be done. Early in 1989, GAO testified several times before congressional committees and provided a frame- work for steps Congress should take to resolve the S&L crisis.16 About this time Congress began debating proposals for the so-called S&L "bailout" bill. In February GAO issued a report detailing its comprehensive set of proposals for solving the thrift industry crisis." The recommendations addressed separating FSLIC and FHLBB and reorganizing FSLIC, implementing greater con- trols over insolvent institutions, improving supervision, and restoring FSLIC's reserves financed as much as possible from thrift industry contributions.

Also during 1989, GAO empha- sized in several testimonies and reports its proposed legislative pack- age to improve audit and management reporting in financial institutions."8 GAO's review of the records and examination reports for some of the largest failed S&L institutions revealed that all of the thrifts in its review had indications of fraud and insider abuse and many violated laws and regulations by inaccurate ap- praisals for real estate investments, excessive loans for single borrowers, business with prohibited persons or insiders, and inadequate assessments of borrowers' ability to repay loans. 19 The report also pointed out that management at these thrifts was often unresponsive to the concerns of regulators and violated written agreements or enforcement actions. GAO recommended requiring each insured thrift to prepare an annual management report certifying compliance with applicable laws and regulations and assessing the institution's internal control structure. In a separate report GAO also pointed out the failure of CPA audits to identify and report on significant S&L problems.20

Another area of GAO's focus during 1988 and 1989 was analysis of FHLBB's resolution of insolvent thrifts. Because of FSLIC's limited resources, FHLBB had resorted to some creative financing techniques by issuing notes, guarantees, and federal tax credits to acquirers of insolvent thrifts. GAO had warned Congress

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The Savings and Loan Crisis

in September 1988 that the costs of these transactions would be greater than projected and that FSLIC's use of these transactions should be limited. 21 Of particular interest to Congress was the FHLBB's sale of insolvent thrifts under assistance agreements that exposed the government to risk for up to 10 years. They in essence guaranteed the value and yield on $58.5 billion in assets of 181 failed thrifts sold to 91 acquirers-- referred to as assisted thrifts. GAO reported that the assisted thrifts could be thinly capitalized, were dependent on FSLIC assistance, had a competitive advantage over un- assisted thrifts, and did not have incentives to limit the government's costs and risk exposure by maximiz- ing the net recovery from the disposi- tion of covered assets. GAO also alerted Congress to the costs which would result from lost tax revenues in addition to the $49 billion loss reported by FSLIC.22

GAO worked closely with the congressional committees throughout 1989 as they developed legislation, and in August 1989 Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). Included in the legislation was a requirement for GAO to undertake an 18-month comprehensive study of issues related to reform- ing the deposit insurance system. This study involved a thorough analysis of the incentive problems, both regulatory and economic, asso- ciated with deposit insurance, ana- lyzed the policy options relating to reform, and discussed how these problems should be addressed. The report issued in March 1991 also provided a comprehensive set of reform recommendations that included strengthening the supervisory process, limiting financial institutions' economic incentives to take risks with insured deposits, and moderniz- ing the regulatory structure and process for financial institutions. 23 GAO has testified several times before Congress on its policy recommendations and is currently working with the congressional committees on pending reform legislation. Congress now looks routinely to GAO for input on major policy issues facing the financial industry.

GAO's most recent report on

thrifts focused on the future of the thrift industry. GAO looked at the function of the industry and eval- uated the potential impact of the stricter qualified thrift lender test included in the 1989 FIRREA legislation which required thrifts to hold 70 percent of their assets in housing- related investments. While the report did not attempt to determine what the exact test level should be, it suggested that Congress consider amend- ing FIRREA to leave it at the previous 60 percent because increasing the level might increase risks to the industry.2

Currently, GAO is focusing on

. . . FHLBB had resorted to some creative financing techniques by issuing notes, guarantees, and federal tax credits to acquirers of insolvent thrifts.

many similar policy issues, particularly those related to supervision and safety and soundness regulation, which are now facing the banking and other financial services industries. GAO also continues to monitor the condition and the risks of the financial services industries to identify emerging problems and evaluate solutions. In addition, GAO is moni- toring the activities of the Resolution Trust Corporation, which is now re- sponsible for disposing of failed thrift assets.

What Have We Learned? It is clear that GAO has come a

long way in the last decade. There is a greater understanding of the com- plexities of the issues and the level of analysis required for assisting the policymaking process. From GAO's experience during the last decade, several key factors are important in this process.

First, it requires credibility, particularly in the area of analytical

capability, which takes a lot of time and effort to build. GAO started from scratch and tried to develop this new area primarily from within, and hired a few people with outside expertise along the way. The learning curve could probably have been bridged sooner if more expertise had been available earlier. GAO also had to carefully coordinate the financial analysis work that was being done by its different groups, particularly the financial audit work performed by the accountants and the economic and program analysis being done elsewhere in GAO. The combination of these different perspectives strengthened GAO's analysis of the problems and their causes.

Second, information is critical to understanding what is happening and identifying issues. GAO recognized the inadequacy of available information and developed its own databases which were key factors in its ability to identify industry problems. GAO's access to the examination reports and financial records for financial institutions was also important.

Third, it was necessary to under- stand the supervisory and regulatory processes and agencies, the complexi- ties of the financial markets, and the viewpoints of major consumer and industry groups impacted by the financial industries. It takes a long time to build this understanding and GAO continues to develop it.

Finally, key policy issues require priority status if they are to be adequately developed. During the decade, GAO dramatically increased the resources it devoted to issues relating to financial services regulation. From this effort, GAO has gained a much better understanding of the complex factors that affected the condition of the thrift industry and its insurance fund. GAO can apply the lessons learned in the S&L experience to improve its analyses of the many other difficult policy issues that continue to plague the financial services industry.

Notes *The opinions expressed in this paper are

solely those of the author and do not repre- sent official GAO positions.

1. See the GAO Review, Vol. 17, Issue 1,

450 PS: Political Science & Politics



Winter 1982, pp. 36-38, for a discussion of GAO's initiation of financial regulatory audits.

2. See GAO's report, Formal Supervisory Process for Savings and Loan Associations Should Be Strengthened, GGD-81-91, Sep- tember 17, 1981.

3. See GAO's report, The FSLIC Insur- ance Fund-Recent Management and Out- look for the Future, GAO/GGD-84-3, Octo- ber 14, 1983.

4. See GAO's testimony, Changes in the Financial Services Industry and Their Impact on Federal Regulation, before the Senate Committee on Banking, Housing, and Urban Affairs, June 16, 1983.

5. See GAO's report, Thrift Industry Re- structuring and the Net Worth Certificate Program, GAO/GGD-85-79, September 24, 1985.

6. See GAO's testimony, GAO's 1984 Financial Audits of the FDIC and FSLIC, before the Subcommittee on Financial Institu- tions, House Banking Committee, September 12, 1985.

7. See GAO's report, Thrift Industry Problems: Potential Demands on the FSLIC Insurance Fund, GAO/GGD-86-48BR, Feb- ruary 1986.

8. See GAO's report, Thrift Industry: Cost to FSLIC of Delaying Action on Insol- vent Savings Institutions, GAO/GGD-86- 112BR, September 1986.

9. See GAO's testimony, Problems in Reporting by Depository Institutions, before the Subcommittee on Oversight and Investi- gations, House Energy and Commerce Com- mittee, April 10, 1986.

10. See GAO's reports, Thrift Industry: Forbearance for Troubled Institutions, GAO/ GGD-87-78BR, May 7, 1987, and Thrift Industry: The Management Consignment Program, GAO/GGD-87-115BR, September 10, 1987.

11. See GAO's testimony, The Federal Sav- ings and Loan Insurance Corporation-- Financial Condition and Recapitalization Issues, before the House Banking Committee, T-AFMD-87-4, March 3, 1987, and GAO's report, Thrift Industry: The Treasury/Federal Home Loan Bank Board Plan for FSLIC Recapitalization, GAO/GGD-87-46BR, March 3, 1987.

12. These views were contained in a letter dated March 6, 1987 from William B. O'Connell, President of the U.S. League of Savings Institutions, to GAO's Comptroller General.

13. See GAO's report, Financial Audit: Federal Savings and Loan Insurance Cor- poration's 1986 and 1985 Financial State- ments, GAO/AFMD-87-41, May 27, 1987.

14. See GAO's report, Financial Audit: Federal Savings and Loan Insurance Cor- poration's 1987 and 1986 Financial State- ments, GAO/AFMD-88-58, July 5, 1988.

15. See GAO's testimony, The Federal Savings and Loan Insurance Corporation-- Current Financial Condition and Outlook, before the Senate Committee on Banking, Housing and Urban Affairs, T-AFMD-88-12, May 19, 1988.

16. See GAO's testimonies, Failed Finan- cial Institutions: Reasons, Costs, Remedies and Unresolved Issues, before the House Banking Committee, GAO/T-AFMD-89-1, January 13, 1989; Resolving the Savings and Loan Crisis, before the House Budget Com- mittee, GAO/T-GGD-89-3, January 26, 1989; and before the Senate Banking Committee, GAO/T-GGD-89-4, February 2, 1989.

17. See GAO's report, Troubled Financial Institutions: Solutions to the Thrift Industry Problem, GAO/GGD-89-47, February 21, 1989.

18. See GAO's testimonies, The Need to Improve Auditing in the Savings and Loan Industry, before the House Banking Commit-

tee, GAO/T-AFMD-889-2, February 21, 1989; and Failed Thrifts: Internal Control Weaknesses Create an Environment Condu- cive to Fraud, Insider Abuse, and Related Unsafe Practices, before the Criminal Justice Subcommittee of the House Judiciary Com- mittee, GAO/T-AFMD-89-4, March 22, 1989.

19. See GAO's report, Thrift Failures: Costly Failures Resulted from Regulatory Violations and Unsafe Practices, GAO/ AFMD-89-62, June 16, 1989.

20. See GAO's report, CPA Audit Quality: Failures of CPA Audits to Identify and Report Significant Savings and Loan Prob- lems, GAO/AFMD-89-45, February 2, 1989.

21. See GAO's testimony, The Federal Savings and Loan Insurance Corporation's Use of Notes and Assistance Guarantees, before the House Banking Committee, GAO/T-AFMD-88-17, September 8, 1988.

22. See GAO's reports, Failed Thrifts: Bank Board's 1988 Texas Resolutions, GAO/ GGD-89-59, March 11, 1989, and Failed Thrifts: FDIC Oversight of 1988 Deals Needs Improvement, GAO/GGD-90-93, July 19, 1990.

23. See GAO's report, Deposit Insurance: A Strategy for Reform, GAO/GGD-91-26, March 4, 1991.

24. See GAO's report, Thrifts and Hous- ing Finance: Implications of a Stricter Quali- fied Thrift Lender Test, GAO/GGD-91-24, April 30, 1991.

About the Author Teresa Anderson is a Senior Evaluator with

the U.S. General Accounting Office, which she joined in 1978.

Political Science and the Crisis

Political Science and the Savings and Loan Crisis

Ronald C. Moe, Library of Congress

The juxtaposition of "political science" with the "savings and loan crisis" is interesting in part because it appears a peculiar pairing. What does, or should, political science as an academic discipline have to do with the current crisis in the savings and loan industry? A case can be made, and indeed is arguably the present dominant view within the discipline, that political scientists ought not to seek to be involved in any systematic way with public sector management problems or with governance generally. Following this reasoning, political science ought not

to be interested in the savings and loan crisis other than, possibly, to study it after the fact as a political phenomenon.

There are other political scientists, however, who are uneasy with this passive view of the discipline. They have seen the emergence of a massive institutional crisis in the financial system of the nation and no one has thought to seek their advice and counsel towards a solution to the crisis except for them to participate as taxpayers in picking up the bill. But of even greater concern to many of the thoughtful in these ranks is

the realization that if someone were to call upon the discipline for advice and assistance, the discipline might have little to contribute. Few of the leaders in our discipline have expertise in the management of complex fields. Indeed, it is unusual today to find political scientists with any experience at all in governmental institutions or affairs. The estrange- ment between political science and the governance process of the Repub- lic appears nearly complete.

This was not always the case. Political scientists were once very much involved in matters of impor-

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what did we know and when did we know it? gao's role in analysis of the savings and loan crisis

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