A Review Essay: The Savings and Loan Crisis by James Schaefer University of Evansville
In the winter of 1989, the seriousness and magnitude of the S & L crisis became everyday news. Fraud, insider abuse, poor management practices, regulation, and deregulation have all been stated as major contributions to the problem. While the full costs of the crisis, ultimately to be borne by U.S. taxpayers, will not be known for some time, official estimates (including interest) have exceeded $400 billion [U.S. Congress. House Committee on Ways and Means 1989, p. 20], prompting predictions that the industry itself has been destroyed.
The accounting profession has two areas of risk exposure from the S & L Crisis. One is the use by S & L’s of regulatory accounting principles (RAP) instead of GAAP. The second is the concern that the auditors, while not responsible for the crisis, could have “at least sent up a warning shot” [The New York Times, March 12, 1989]. These two risks provide important research opportunities for accounting historians.
REGULATORY ACCOUNTING PRINCIPLES
From 1932 until 1989 federally chartered savings and loans (thrifts) were regulated by the Federal Home Loan Bank Board.
One function of the Bank Board was to determine the account-ing procedures (RAP) to be used by thrifts. Regulatory net worth is based on RAP, as opposed to net worth based on GAAP. Both Pilzer and Brumbaugh include discussions on the importance of RAP to the S & L crisis. Pilzer provides anecdotal evidence of the problems in using RAP [pp. 75-76; 125-126; 132-134], focusing on how an S & L could sell a mortgage at a loss and then amortize the loss in future periods. In contrast, GAAP treatment would recognize the loss in full during the year of the sale. Pilzer argues that RAP encouraged thrifts to sell home mortgages and use the proceeds to make riskier investments (i.e., junk bonds) in hopes of earning higher returns, and suggests that such reinvestment was widespread among thrifts in the 1980s.
Brumbaugh devotes considerable discussion [pp.36-66] to the differences between RAP and GAAP, explaining how the difference in RAP treatment of loan losses originated as well as documenting the extent to which it occurred. Through 1980, RAP and GAAP net worth for federally-insured thrifts were virtually identical. However, in 1981 the Bank Board passed a resolution allowing thrifts to amortize the losses on any assets sold over the remaining contractual life of the assets. Brumbaugh then presents tables which depict the components of the “RAP-GAAP net worth differential” he has calculated, which rose, by 1984, to $9 billion, of which $6 billion was from the deferral of loan losses. He then argues that the number of thrifts insolvent according to RAP was substantially less than the number insolvent according to GAAP, thereby reducing the candidates for closure by the FSLIC. While the FSLIC had been grossly underfunded due to a massive influx of newly-allowed brokered funds since 1983 [Pilzer, p. 14], RAP apparently concealed the financial woes of the industry.
The potential for criticism of the accounting profession re-garding the accounting principles used by thrifts is consider-able. While the traditional accounting standard-setting mecha-nism was not involved, accountants were employed by the Bank Board, the thrifts, and, most obviously, the CPA firms auditing the thrifts. Surely some accountants recognized that allowing the deferral of losses was a serious departure from the conservatism principle which underlies GAAP, requiring a different interpretation of thrift financial statements and data than used for GAAP statements. The defense that the deferral of loan losses
was an “accounting thing” is of little consolation to the general public, which will ultimately pay for the S & L debacle through increased taxes and loss of other government services.
THE ROLE OF THE AUDITORS
Many of the recently-failed thrifts received unqualified au-dit opinions prior to closing. While the auditing profession can offer the standard replies to criticism of their ability to foresee the future or detect fraud, this also is of little consolation to American taxpayers. A careful interpretation of the books being considered here suggests two audit areas which could benefit from a historical analysis of the savings and loan crisis — inflated valuations and integrity of management.
Both Pilzer and Pizzo et al. cite numerous examples of thrift owners “flipping” properties back and forth among themselves, artificially inflating the value of the land in the process. For example, Pilzer investigated deed records in Texas [pp. 93-95] to show how property apparently escalated in value from $17.25 million to almost $65 million in two years. Every transaction was thrift-financed, with no money down. Pilzer provides other examples of these transactions, leaving the impression that this practice was not uncommon. Pizzo et al. detail similar land flips throughout their book, as well as a policy by some thrifts of requiring borrowers to put a portion of the loan proceeds in reserve to cover the first two years’ worth of interest [pp. 29, 209]. The purpose of such reserves was to make a loan appear current.
Traditionally auditors have focused on performance (pay-ment of principal and interest as scheduled) when evaluating existing loans. Further, thrifts, when considering potential bor-rowers for loans, placed the primary emphasis on the quality of the collateral and then considered the creditworthiness of the borrower [McEachern, 1990, p. 50]. Banks, on the other hand, generally have focused their attention on the borrower’s credit quality first and then on the collateral of the loan [ibid]. Hence the independent auditors of thrifts were not likely to be as con-cerned with the quality of loan portfolios as they perhaps should have been.
The integrity of management in certain thrifts is another area which should have warranted more auditor attention. One example of management abuse reported by Pilzer [pp. 99-112] is Vernon Savings and Loan, of Dallas, Texas. Although Vernon was profitable at the time of its purchase in 1981, a new owner W.D. Dixon subsequently spent millions of its funds on artwork and exotic cars before federal regulators closed the thrift in 1987. Pizzo et al. also discuss Dixon’s abuse of Vernon Savings and Loan [pp. 188-199] and involvement of convicted felons in thrift management. In fact, the central theme of the Pizzo et al. book is that management abuse of thrifts was rampant in the 1980s. In each of the few dozen failed thrifts examined, they found evidence of a purposeful and coordinated system of fraud, and conclude:
A financial mafia of swindlers, mobsters, greedy S&L executives, and con men capitalized on regulatory weaknesses created by deregulation and thoroughly fleeced the thrift industry (p. 298).
While students of the S&L crisis may not be convinced of the pervasive involvement of organized crime in insolvent thrifts suggested by Pizzo et al., government reports suggest that criminal activity was a central factor in many thrift insolvencies [e.g., see General Accounting Office June, 1989]. Hence, it might be prudent for auditors to investigate more carefully the background of top management before accepting new clients. A scientific analysis of the background of individuals who managed now-bankrupt thrifts could provide evidence as to the validity of Pizzo et al. ‘s conclusion. If management cannot be assumed to have a reasonable level of integrity, extra care would be necessary in all levels of audit engagements.
CONCLUSION
All three books reviewed here are recommended for re-searchers interested in the savings and loan crisis. Brumbaugh is an obvious starting point for those interested in the financial accounting aspects of the industry. Both Pilzer and Pizzo et al. provide good discussions of the history of the industry as well as insight into the regulatory problems involved. Both Pilzer and Pizzo et al. also conclude that the entire industry is insolvent and has been eliminated as a viable part of the financial services sector. If the industry is indeed dead, accounting historians may begin their work in earnest.
REFERENCES
McEachern, Douglas J., “The Outlook for the Thrift Industry: A Survivor’s Guide,” Journal of Accountancy (November 1990): 49-57.
New York Times, (March 12, 1989), Section 3: 1.
U.S. Congress, House Committee on Banking, Finance and Urban Affairs. Sub-committee on Financial Institutions Supervision, Regulation and Insurance. 1989. Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (H.R. 1278). Hearings before the Subcommittee (March 8, 9 and 14).
U.S. General Accounting Office, Thrift Failures. Costly Failures Resulted From Regulatory Violations and Unsafe Practices, 1989. Report to the Congress, GAO/AFMD-89-62.
