President Reagan appointed Edwin J. Gray to the Bank Board in early 1983 with the expectation that he would become chairman when Pratt resigned a few months later.
Gray was a longtime friend of the president, and had served as his press secretary in California and then as a public-relations officer for a large San Diego S&L run by Gordon Luce, a member of the President’s “kitchen cabinet.” Gray served in the White House as a domestic policy advisor for President Reagan. He was valedictorian of his high school and received his BA in journalism. Like the president, he was a Democrat who became a conservative Republican. Gray led an antitax initiative in San Diego. He loved the president and his policies. Gray believed in deregulation. He freely told
people that the president appointed him to make the league happy—it considered him a patsy.
Gray soon took positions that put him in opposition to the president he loved, his party, and his own philosophical views. He had nothing to gain from this
transformation. He did not welcome it. He knew it would ruin his career and that he would lose what he most treasured, Ronald and Nancy Reagan’s support and
friendship. He knew that the counterattack would be savage, personal, and effective.
He would make too many powerful enemies and he would have few effective allies.
Some people fight because they enjoy it, others because that is how they were trained; some because they are thin skinned, others because they are bullies; some because they are irrational, and others because they are cornered and have no other hope of survival. Soldiers fight mostly for their close comrades. Young males fight because they are desperately afraid of being afraid. Drug sellers fight because if they do not intimidate, they die. Most of the reasons people fight are bad ones. Gray did not fight for any of these reasons. Gray was not cornered: if he were unwilling to support S&L deregulation, he could have gone home to San Diego.
Gray was not naturally brave. His hands shook, he couldn’t sleep, he chain-
smoked, and his face became pallid. He shrank from confrontation. He was not calm under pressure. He was so nervous that he could not concentrate. He projected
nervousness, making others uncomfortable. He did not have “the right stuff.” John Glenn, the astronaut who exemplified the right stuff, disdained Gray. Glenn became one of the Keating Five (the five U.S. senators who tried, at Charles Keating’s behest, to intimidate Gray), and Gray refused to back down to their pressure. Perhaps we should reexamine our definition of “the right stuff.” It is how far Gray had to move philosophically, at what personal cost, and in a manner so at odds with his basic
personality that makes him both the most unlikely of heroes and so heroic. But that is not how Gray’s chairmanship began.
GRAY’S INITIAL PRATFALLS
Gray continued Pratt’s policies during his first five months as chairman. He imposed a hiring freeze. He adopted a creative RAP rule. He approved disastrous acquisitions by men who would become infamous control frauds. He gave speeches lauding
deregulation and urging S&Ls to make use of the new powers. He fought the last war, constantly reminding S&Ls of the need to reduce interest rate risk. He slowed the rate of S&L closures. Like Pratt, he capped FSLIC spending at a ridiculously inadequate level in order to show a small increase in the FSLIC fund at the end of 1983 ($6.4 billion). He approved goodwill mergers.
He made no improvement in the moribund enforcement efforts or in the
dysfunctional examination and supervision systems. Indeed, he harmed supervision by agreeing to a proposal to move the headquarters of the 9th District from Little Rock, Arkansas, to Dallas, Texas. The new FHLB-Dallas decided to save money by being cheap when paying for relocation. The overwhelming majority of its
supervisors resigned in late 1983.
Gray did not clean up the “change of control” system that allowed almost anyone to acquire an S&L. By continuing Pratt’s policies, Gray increased the damage the control frauds later caused.
RIGHT WAR, WRONG TARGET
Donald Regan was the head of Merrill Lynch before he became treasury secretary during President Reagan’s first term. He made Merrill Lynch the dominant deposit broker.1
Deposit brokers seek S&Ls and banks offering the highest interest rate on insured deposits. Deregulation allowed banks and S&Ls to compete on interest rates. Insured depositors had no risk of loss or even inconvenience. In order to maintain public confidence, if the FSLIC liquidated an S&L, it paid the depositors in full within days.
An insolvent S&L that was closed on Friday afternoon would reopen on Monday morning. Deposit brokers fueled the growth that made control frauds ideal Ponzi schemes. An S&L could raise hundreds of millions of dollars in as little as three days through the brokers.
The Bank Board and the FDIC simultaneously adopted rules in March 1984
restricting insurance for accounts placed by brokers. The rules could not work. S&Ls
could grow almost as rapidly by advertising a slightly higher interest rate and then
“dialing for dollars.” S&Ls created phone banks to call prospective depositors and solicit deposits. Any S&L could raise tens of millions of dollars in a week without using brokers.
The Bank Board’s authority to restrict deposit insurance for brokered deposits was weak. My predecessor as Bank Board litigation director, Harvey Simon, advised Gray that the brokers would likely win their lawsuit if he adopted the rule. Simon proved correct.
Treasury Secretary Regan opposed the rule. He believed in deregulation, and he thought that brokers helped customers. Regan was Mehle’s boss when he testified that insolvent S&Ls should grow rapidly and that the industry’s fast growth showed that it was sound. Regan was convinced that President Reagan shared his views. Gray made a powerful enemy. Regan sought to drive him to resign.
The deposit broker rule was a mistake. It would not have worked even if we had won the case. We had more effective ways of limiting growth and the clear statutory authority to use them. The rule diverted resources we could have used more profitably against the control frauds.2
GRAY’S “ROAD TO DAMASCUS” EXPERIENCE
Empire Savings made famous the “land flip.” The S&L paid the small fry (which it called “minnows” or “guppies”) up to $50,000 to lend their name to this fraud. The guppies sat at a long table. A big fish started the land flip by selling a piece of
undeveloped (“raw”) land to Guppy One for $2,000 an acre. Guppy One sells it to Guppy Two for $4,000 an acre. This continued until another big fish agreed to pay
$50,000 an acre. The S&L would then loan money to the big fish to purchase the raw land at this price. In five minutes, the “market” value of the land rose twenty-five- fold. The big fish was a residential real estate developer who was purportedly going to build thousands of townhouses.
It was impossible, of course, for such a developer to create a profitable project.
The developer was part of a fraud, and he made money in several different ways. The S&L paid him an up-front “profit.” The developer hired related entities at generous rates to do the construction. The developer gained directly by having a hidden interest in the construction group or through kickbacks for awarding contracts. The
construction group charged high rates but provided inferior work and pocketed the difference. One of the scams that caused losses at Empire Savings occurred when contractors used one-fifth of the concrete needed to construct a road properly. The roads soon buckled. Empire Savings also funded the construction loans in full
without tying disbursements to completion of construction.
The result was a disaster of epic proportions. Because other control frauds joined with Empire Savings to run the same scam and because they all (semi-) built their projects in the same area (along the “I-30 corridor” in Garland, Texas, near Dallas), the disaster was concentrated and stretched for miles.
The Bank Board examiners hired an old-time Texas real estate expert to help them figure out how bad the mess was. He decided that you had to see it to believe it. He videotaped a tour of the I-30 corridor. There were thousands of partially completed units left open to the elements and arsonists. Many units had no construction, just the concrete pad. We dubbed them “Martian landing pads.” The images on the tape were so revolting that they created horror in everyone who saw them. He shot some of it from a small plane, which provided panoramic views of devastation. His narration increased the effect. It was so disturbing because it was artless. Imagine a strong
Texas accent that remains calm and matter-of-fact while presenting a nightmare. Gray watched the film on March 14, 1984 (Day 1993, 156–157). He told me he wanted to throw up when he saw it.
He showed the tape to as many senior officials as possible, including Paul Volcker (Day 1993, 162). Kathleen Day interviewed one of the key people Gray showed the tape to, the House Banking Committee chief of staff, Paul Nelson. Whereas Volcker was horrified, Nelson responded, “Gray’s the regulator, not us…. That’s his job to stop this. Why am I watching this?” (ibid.) The smaller incidents are often the most revealing. Paul Nelson’s reaction illustrates why congressional oversight failed
throughout the critical years of the debacle. Gray was stunned, outraged, and determined to prevent any future Empire Savings from spawning similar horrors.
Nelson and House Banking Committee chairman St Germain did not see that their deregulation had created the environment that produced the wave of control fraud.
They were annoyed with the messenger.
Notably, he did not try to show the film to President Reagan. Gray and the
president (who became famous as “the great communicator”) neither met nor talked while he was chairman. Even when Regan was pushing for his resignation, Gray
never tried to use his friendship with the president to have him call off the dogs. Many of us asked him why. His answer was always the same: “You don’t know him. You can’t do it; it’s impossible.” The president was an extraordinarily hands-off manager.
He did not ask people like Gray for advice about how to deal with the debacle.
Treasury and the OMB talked to him. They had two contradictory messages
throughout his presidency—there is no crisis, and our top priority is making sure that the public does not learn of the crisis. President Reagan’s autobiography ignored the
debacle, at the time the largest financial scandal in U.S. history.
The mythic part of the story about the Empire Savings videotape is that it produced an instantaneous transformation in Gray: he rode in as a deregulator, the truths in the film knocked him off his horse, and he awoke as the Great Reregulator. Gray had begun transforming himself into a reregulator before he saw the film. Further, Gray did not complete his transformation until years after he saw the film. The film was, however, important in speeding Gray’s transformation and the intensity of the war against the control frauds.
GRAY MAKES ENEMIES BY STOPPING TEXAS, CALIFORNIA, AND FLORIDA FROM CREATING NEW S&LS
Gray’s first effective counterattack against the control frauds assaulted the de novos.
Taggart (the California Department of Savings & Loans commissioner) approved 200 new California charters by early 1984. Texas and Florida approved dozens of new charters. Gray adopted a rule in November 1983 requiring de novos to have 7 percent capital—over twice the requirement for other S&Ls—in order to receive FSLIC
insurance.
Gray’s second act was more decisive. He refused to approve FSLIC insurance for de novos from California, Texas, and Florida unless they improved their regulation.
This was one of the most effective actions possible against control frauds. There would have been hundreds of additional control frauds but for Gray’s moratorium.
However, it enraged all three state commissioners and state and federal politicians representing California, Texas, and Florida, states with powerful congressional and state officials. The list of Gray’s powerful opponents grew.
The related problem was that Gray had no clear legal basis for imposing a moratorium. His action was logical: none of the states had remotely adequate
regulatory resources to deal with their existing charters. It was irresponsible of them to increase the number of charters. Gray tried to convince them to stop the approvals until they could build up their staffs. The three commissioners refused. Gray’s action was desirable; but was it legal?3
UNRESTRICTED WARFARE: THE NET WORTH AND DIRECT INVESTMENT RULES
Gray proposed the net worth and direct investment rules in early 1984. He focused, however, on the deposit broker rule. He saw it as a direct way to limit growth, which he considered the central problem. When the courts struck down the deposit broker rule, these other two rules became his top priority. The Bank Board designed them to
stop any future Empire Savings.
The de novo rule and Gray’s moratorium on granting FSLIC insurance to new charters in California, Texas, and Florida had substantial support within the industry;
they restricted future competitors. The deposit broker rule had some support within the traditional S&Ls. The proposed direct investment rule (which limited such
investments to 10 percent of total assets) did not affect many S&Ls.4 Gray did not expect the direct investment rule to spur major opposition. Gray designed the net
worth rule to end extreme growth. He knew that the industry would oppose it because so many S&Ls were trying to “grow out of their problems.”
GROWING PAINS
The idea of growing out of their problems was seductive to many S&Ls. The amount of growth required, however, was enormous. When interest rates are high, home sales slow and it is hard for a mortgage lender to grow, even slowly. The solution was to grow rapidly by investing in much higher-yield (and higher-risk) assets. The higher the yield of the new assets, the less growth an S&L needed in order to grow out of its problems. Deregulation made this solution possible.
FALLACY OF COMPOSITION
One of the standard logical fallacies is that of composition. Logicians warn that the fact that something is true in a particular case does not prove that it will hold true when applied simultaneously to many cases. An individual S&L might be able to grow out of its problems, but an industry cannot. Indeed, it is a prescription for disaster to try.
Some critics claim that Pratt expressly encouraged S&Ls to grow out of their
problems. Pratt was generally careful to avoid going that far. Nevertheless, he gave the industry the ability to grow massively, and he took no action to stop the large number of S&Ls that began to grow rapidly. The results were, predictably, disastrous.
THE ADC PONZI SCHEME
The proposed net worth rule restricted growth by increasing capital requirements for faster growing S&Ls. Gray proposed to reverse the Bank Board’s prior policy, five- year averaging, which reduced the capital requirement for fast growers. Gray acted because of the tendency of fast growers to become the worst failures. The agency did not understand the acquisition, development, and construction (ADC) Ponzi scheme fully when it drafted the rule. This was ironic because the rule struck the control
frauds’ Achilles’ heel and proved the most critical act of reregulation. A Ponzi scheme
operates by growing rapidly and using a portion of the new money brought in to pay off the old investors while the fraudster pockets the remainder. Pilots say, “Speed is life.” For a Ponzi, growth is life.
S&L Ponzis invested in assets that had no readily ascertainable market value and that allowed S&Ls to treat (fictitious) noncash income as real for GAAP purposes.
Professionals, like appraisers, determine value when there is no clear market value for an asset. Every S&L control fraud was able to get top professionals to overstate asset values massively and to get a clean opinion from a Big 8 auditor blessing its fake
financial statements. The advantage of using noncash “income” as a fraud vehicle was that it guaranteed production of the income.
The “acquisition” in ADC refers to buying raw land. “Development” means adding improvements like sewers, utility lines, and roads. “Construction” meant creating a commercial building or a multifamily residential project. Control frauds called their ADC transactions loans and structured them as loans, but the typical ADC loan was really a direct investment. The law, the fields of economics and finance, and
accounting all agree: if the economic reality is that the lender is taking an equity risk, then the transaction is a direct or equity investment, not a loan. If the success of the underlying project (such as the commercial office building being constructed)
determines whether the borrower repays the S&L, then the lender is assuming an equity risk.
Big 8 auditors—despite three attempts by the profession to prevent the abuse—
consistently blessed the accounting of ADC transactions as loans. Treating ADC deals as loans created extraordinary (fraudulent) income and hid enormous real losses.
S&Ls combined accounting fraud with deregulation and massive growth to create the ideal Ponzi. If the auditors had required the control frauds to account for their ADCs as direct investments, they could not have recognized the fictitious income.
The typical control fraud made ADC loans with the following characteristics.
• There was no down payment.
• There were substantial up-front points and fees.
• All of those points and fees were self-funded: the S&L loaned the buyer the money to pay the S&L the points and fees.
• The term of the loan was two or three years.
• There was no repayment of principal on the loan prior to maturity. (The loan was interest-only, or nonamortizing.)
• The S&L self-funded all of the interest payments. The S&L paid itself the interest
when it came due out of an interest reserve. The S&L increased the borrower’s debt by an amount equal to the interest reserve.
• The interest rate on the loans was considerably above prime.
• The borrower had no personal liability on the debt (the loan was nonrecourse). His construction company was indebted, but the developer was not. He did not
provide any meaningful personal guarantee of his company’s debt.
• The developer pledged the real estate project (the collateral) to secure the loan.
• The loan amount equaled the (purported) value of the collateral.
• It was common for the borrower to receive at closing a developer’s profit that could represent up to 2 percent of the loan balance.
• It was common for borrowers to give S&Ls an equity kicker, an interest in the developer’s net profits on the project. At first, these kickers often exceeded 50 percent. After the accounting profession issued a “notice to practitioners” that said a 50 percent equity kicker was evidence that the transaction was not a true loan, it became common to give a 49 percent interest. (For the characteristics in this list, see NCFIRRE 1993a; Black 1993b; Lowy 1991; O’Shea 1991; Strunk and Case 1988; Mayer 1990; Pizzo, Fricker, and Muolo 1989; Calavita, Pontell, and Tillman 1997.)
The implications of these characteristics are not obvious. One has to understand the fraud mechanism, Bank Board regulation, and a bit about accounting to see how
elegant a Ponzi the control frauds created. The first implication is that one can see why the S&Ls were taking an equity risk, not making a loan. The real estate developers were not personally liable to repay the loan. Their companies were not really on the hook either: they used shell companies with no assets to sign the note. The developer would not repay the S&L unless the real estate project succeeded. Indeed, it had to succeed fully because the loan was 100 percent of the projected value; the S&L would lose money if the appraiser inflated that value even slightly. These were not close calls: the typical ADC Ponzi loan was clearly an equity investment. This makes their audit partners’ consistent treatment of them as true loans all the more disturbing.
Cash moved in one direction in an ADC Ponzi scheme: out of the S&L to the developer. The developer typically did not provide an S&L control fraud with any cash—no down payment, no fees or points, and no interest payment. The developer was only required to pay cash when the loan matured, and as I’ll explain, they rarely paid cash even then.
This may seem to be a foolish way to run a fraud, but it is actually clever. The first advantage is that an ADC loan can never default prior to maturity. The Bank Board