VALUED INSIGHTS

Invaluable Valuation Knowledge for the Real Estate Stakeholder

SERIES:
The Savings and Loan Crisis of the 80s:
A Primer for Navigating Today’s Risk
CHAPTER
  1. Reflections On The S&L Crisis: Lessons From The Valuation Profession
    (Published: June 26, 2024)

     

  2. Overview Of The Savings & Loan Crisis – A Real Estate Appraiser’s Perspective
    (Available: July 17, 2024)

  3. Deregulation’s Role
    (Available: July 24, 2024)

  4. Interest Rate Volatility
    (Available: July 31, 2024)

  5. Regional Real Estate Impacts of the S&L Crisis
    (Available: August 7, 2024)

  6. Regulatory Failures & Inaction in the S&L Crisis
    (Available: August 14, 2024)

  7. The Resolution Process: Cleaning Up the S&L Wreckage
    (Available: August 21, 2024)

  8. Legislative & Regulatory Reforms After the S&L Debacle
    (Available: August 28, 2024)

  9. Striking Parallels to the 2008 Financial Crisis
    (Available: September 4, 2024)

     

  10. Corporate Governance Meltdown in the S&L Debacle
    (Available: September 11, 2024)


  11. Conclusion: Safeguarding Valuation Integrity to Prevent the Next Crisis
    (Available: September 28, 2024)
SERIES:
The Savings and Loan Crisis of the 80s:
A Primer for Navigating Today’s Risk
CHAPTER:

Corporate Governance Meltdown in the S&L Debacle

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Author: Reagan Schwarzlose, FRICS | MAI | CRE | CCIM
Published: September 11, 2024

At the core of the savings and loan crisis that ravaged the U.S. financial system in the 1980s were profound lapses in corporate governance, risk management, internal controls and executive accountability across the thrift industry. A toxic combination of speculative investing, outright fraud, lack of board oversight, and misaligned incentives created an environment ripe for catastrophic losses once economic conditions turned.

As the current banking situation continues unfolding, with regional lenders failing and concerns mounting over interest rate risks, liquidity crunches and excessive risk concentrations, experts are raising alarms over eerie parallels to the corporate governance breakdowns that precipitated the S&L debacle decades ago. There are growing calls for reforms to strengthen accountability, clamp down on excessive risk-taking, and insulate the regulatory process before problems potentially metastasize further.

Reagan R. Schwarzlose
FRICS I MAI I CRE I CCIM
CEO | Managing Director
+1-480-440-2842 EXT 06

“We’re seeing shades of the same types of governance failures that allowed the S&L crisis to spiral out of control,” said Lev Menand, a law professor at Columbia University. “Whether it was thrifts blindly ramping up exposures to commercial real estate or banks loading up on interest rate gambles, the common thread is a lack of robust risk management, board oversight and accountability.”

Speculative Bets and Outright Fraud

In the years leading up to the S&L crisis, a combination of deregulation and diminishing capital levels enabled a systematic erosion of lending standards and governance controls as institutions chased higher-yield, higher-risk investments to remain solvent and competitive. This took the form of aggressive overexpansion into new asset classes like commercial real estate, speculative development projects, corporate debt instruments and even outright fraud schemes.

However, many S&L executives and directors lacked the expertise, risk management capabilities and internal control environments to prudently underwrite and manage these complex investments outside their traditional domains of residential mortgages and consumer lending. Rampant self-dealing, conflicts of interest and outright criminal behavior proliferated as a result.

The collapse of Charles Keating’s Lincoln Savings & Loan exemplified these dynamics. Lincoln piled into high-risk commercial real estate deals and junk bonds on the advice of Keating’s business associates, while simultaneously being used as a personal slush fund for Keating’s outside business ventures and investments.

“Lincoln was a complete governance nightmare – reckless bets chasing yield, intertwined conflicts of interest, and a board of directors completely captured by Keating’s influence,” said William K. Black, the regulator who investigated the failure.

When the investments turned sour amid the economic downturn, taxpayers were left holding a $3.4 billion bill to unwind the mess and make depositors whole. The “Keating Five” scandal, involving five U.S. Senators improperly intervening with regulators on Keating’s behalf after receiving $1.3 million in campaign contributions, further exemplified the breakdown of governance and accountability.

“The degree of regulatory capture and industry dominance over the oversight process was really stunning,” said Bert Ely, a veteran financial institutions expert. “It created a culture of willful blindness to rampant abuses that should have been shut down.”

As the current crisis plays out, concerns are mounting about potential conflicts of interest, excessive risk concentrations in areas like commercial real estate, and lack of accountability at some institutions that may have failed to properly model interest rate risks.

“We have to be vigilant about the power of money in politics creating regulatory blind spots and captured dynamics,” said Dennis Kelleher, co-founder of Better Markets. “The public cannot afford to foot the bill for another crisis precipitated by cozy relationships between banks and their overseers.”

Lack of Robust Risk Management

Compounding the speculative activities and fraud was a systemic lack of robust risk management frameworks, internal controls and active board oversight across the S&L industry in the pre-crisis period. With minimal regulatory oversight and capital standards in place, many institutions lacked the governance infrastructure to independently identify, measure, monitor and mitigate their growing risk exposures across new business lines.

“There was essentially no risk management to speak of at most of these S&Ls,” said William Seidman, who led the Resolution Trust Corporation’s Herculean cleanup efforts after the crisis. “The boards of directors were just rubber stamps as executives swung for the fences on high-risk plays like commercial real estate without any independent checks and balances.”

This lack of robust risk management controls created an environment where excessive risk concentrations could build up rapidly without being flagged, stress tested or mitigated through measures like hedging strategies. By the time regulators did finally intervene, the losses had already reached catastrophic levels requiring a $124 billion taxpayer bailout.

“If anything positive came from the S&L debacle, it was a renewed focus on robust risk management, capital planning, stress testing and holding executives accountable when governance lapses occur,” said Seidman. “We simply could not allow that level of unchecked risk-taking to precipitate another crisis.”

In the wake of the current situation, regulators are already scrutinizing risk management practices, capital planning and interest rate hedging strategies at some banks. There are concerns that some firms may have developed outsized exposures to certain asset classes or improperly modeled the impacts of rapidly rising rates on their portfolios.

“We’re stress testing our risk systems and models to gauge our interest rate sensitivity and ensure we have a full grasp of our exposures,” said one senior risk officer at a major bank who spoke on condition of anonymity. “The last thing anyone wants is to be caught flat-footed like the S&Ls were.”

Governance Reforms and Accountability Push

The lasting impacts of the S&L crisis, including the staggering $124 billion taxpayer costs, sparked a wave of outrage over the governance lapses, fraud and regulatory failures that enabled such a systemic meltdown to occur. This precipitated a push for legislative reforms aimed at improving oversight, accountability, and ensuring the “moral hazard” dynamics that contributed to excessive risk-taking would not be repeated.

The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) enacted in 1989 took some initial steps, abolishing the failed Federal Home Loan Bank Board and establishing new capital requirements along with more stringent regulatory enforcement mechanisms like civil money penalties against executives.

However, the push for more robust governance reforms has continued through subsequent decades and major financial crises like the 2008 meltdown. Efforts have focused on strengthening regulator powers to rein in excessive risk concentrations, improving stress testing and capital planning requirements, enhancing board oversight responsibilities, and clawing back executive compensation in cases of wrongdoing.

“The S&L crisis underscored how costly regulatory inaction and lack of accountability can be when governance breaks down,” said Ely. “We cannot allow the same patterns of reckless bets, captured oversight and erosion of controls to brew again.”

The Dodd-Frank Wall Street Reform and Consumer Protection Act represented one of the most comprehensive attempts at governance overhauls in the wake of the 2008 crisis. It mandated new risk committee requirements for large banks, instituted annual stress testing, tried to address “too big to fail” risks through living will requirements, and enhanced prudential standards like liquidity coverage ratios.

However, the legislation has faced fierce industry pushback over perceived excessive regulatory burdens. Major portions like the Volcker Rule’s proprietary trading restrictions have been scaled back or faced implementation challenges and delays.

As the current situation unfolds, calls are growing for a new round of governance reforms to address lingering vulnerabilities exposed by recent bank failures. Specific proposals being floated include:

  • Raising capital and liquidity requirements for banks above certain thresholds
  • Granting regulators more oversight of risk management practices and concentration risks
  • Strengthening regulatory governance and independence from industry influence
  • Enhancing personal liability and compensation clawback provisions for executives
  • Mandating more robust stress testing of interest rate, liquidity and other risk factors

“The fact that we’re seeing these parallels to previous crises emerge so soon after the 2008 meltdown should be setting off alarm bells,” said Kelleher. “We need meaningful accountability reforms and a regulatory system that is truly insulated from capture.”

Senator Elizabeth Warren has been among the most vocal in calling for a crackdown on what she has termed “lousy corporate governance” at banks.

“We cannot allow reckless CEOs to keep putting the entire economy at risk through sloppy risk management and excessive bets on things like interest rates,” Warren said. “We need personal accountability and the threat of clawing back every last bonus when governance failures occur.”

As memories of past crises inevitably fade, maintaining robust corporate governance standards backed by vigilant regulatory oversight remains an ongoing challenge. The painful lessons from the S&L debacle served as an inflection point in rethinking how to mitigate excessive risk-taking that can precipitate systemic shocks.

“We cannot allow the same perfect storm of deregulation, speculative bets, lapsed controls and captured oversight to brew again,” said Ely. “The S&L crisis made clear that governance failures enabling systemic shocks ultimately get paid for by the taxpayers and broader economy.”

Sources:

 FDIC – History of the Eighties Vol 1

 William K. Black – The Best Way to Rob a Bank is to Own One

 The New York Times – Reporting on the Keating Five scandal 

 Quotes from Lev Menand (Columbia), William Seidman (RTC Chair), Bert Ely (expert), Dennis Kelleher (Better Markets), Elizabeth Warren (U.S. Senator)

 Wall Street Journal – “Bank Failures Raise Corporate Governance Concerns” (March 2023)

 American Banker – “The Next Regulatory Battle: Tougher Bank Capital Rules” (April 2023)

 U.S. Congressional Hearings and Proposed Legislation on Governance Reforms

 Institutional Investor – “The Ghost of Charles Keating Still Haunts Banking” (April 2023)