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THE VALUE OF EXPERIENCE An Address by L. WILLIAM SEIDMAN, CHAIRMAN FEDERAL DEPOSIT INSURANCE CORPORATION WASHINGTON, D.C. Before the SAVINGS BANKS ASSOCIATION OF NEW YORK STATE 93rd ANNUAL CONVENTION November 15, 1986 BOCA RATON, FLORIDA Good morning, to it's a pleasure to be meet with a group of bankers who here with you today. It's good have come from hard times to prosperity. In fact, your luck has really changed; the new tax law will require all citi zens — to have two home mortgages as a basic necessity of personal finance new business will abound. FDIC-insured savings banks have been doing extremely well recently. I know of no financial institutions that have experienced anything approaching their improved performance over the past three or four years. is The improvement most apparent in New York, where savings banks have come from an average loss on assets of about two percent this year. are not banks, To say you have done well so fortunate. has to an average profit of over one percent been uneven would be an understatement. Thrift performance overall, — maybe that's Others like that of commercial, an all-time reminded of the opening sentence in Charles Dickens' understatement. I am A Tale of Two Cities: "It was the best of times, it was the worst of times." Many thrift institutions are doing very well, but too many are performing disastrously. A recent conversation with a newly chosen board member of an S&L in the FSLIC consignment program provides an example of just how poorly some thrifts are the Association, "We need to grow. to pay salaries. doing. Puzzled by the above-market rates being he questioned the heavy emphasis on growth. paid by He was told, So few of our loans are paying, we need the deposits just - Today, 2 - I would like to briefly review the recent experience of thrifts as well as how the FDIC dealt with problems in the industry. I believe that experience has important implications and lessons for the FDIC, particularly in how to handle today's bank failures. years hold some I also believe that the past several important lessons for thrifts in how toapproach today's economic and business environment. When interest rates rose dramatically between of funds for savings banks skyrocketed. 1980 and 1982, the cost Interest margins soon turned negative. The situation was worst for New York City savings banks, many of whom had large portfolios of long-term, low-yielding corporate bonds and FHA and VA loans with yields below six percent. 10 percent in as 350 basis 1982, points some insolvent. New York City savings banks were on assets. if assets were valued at When the average cost of funds exceeded losingas much Book capital was wiped out for some and, market, nearly all savings banks would have been For the weakest, the extent of that insolvency reached 30 percent. There was ample evidence of interest rate risk in the 1960s and 1970s. Some thrifts learned from these early experiences and moved to reduce their exposure to rate increases. And they fared better in the crisis. banks and their regulators, tial problem. Virtually including the FDIC, nobody anticipated Most savings largely ignored the poten the severityof the interest rate increase that occurred during the early eighties. Between November 1981 and October 1982 the FDIC assisted mergers of -3- 11 failing all but savings banks with two of the cases banks. the total assets institutions in excess were acquired In by other savings In most of the transactions, the FDIC assumed considerable interest rate risk by guaranteeing margins on acquired assets. ments, of $15 billion. known as income maintenance agreements, its cost considerably. Through these arrange the FDIC was able to reduce Initial estimates of FDIC costs for these transactions totaled $1.8 billion — about 12 percent of the assets involved. Had the FDIC effected clean purchase and assumption transactions with assets marked to market, we estimate the cost would have been twice as much. It is important to understand the FDIC was not betting on lower rates, the $1.8 billion esti mate assumed constant rates. Of course, rates did decline, and dramatically so, in the last couple of years. As a result, FDIC costs were further reduced and the cost of the 11 assisted mergers will turn out to be only two-thirds of the $1.8 billion. In October 1982, Congress enacted the Garn-St Germain Act which initiated a net worth certificate program for thrifts, a program that served to halt (or at least materially slow down) the forced merger of failing thrifts. The FDIC did not favor net worth certificates, arguing that they imposed undue restriction fail. As good soldiers, the FDIC implemented the program quickly and generous ly. banks on FDIC policy and kept afloat institutions that should The FDIC disbursed $719 million in net worth certificates to 29 savings representing $38 billion in assets. Participation will recall, when book net worth dropped below three percent. could begin, you -4- A few of the participants would have survived without the program due to the interest rate decline which began in the summer of 1982. This may be proof of Greenspan's law which says that by the time the government acts, the need for action has passed. certificate saved the program kept a Nevertheless, it is clear that the net worth considerable number FDIC a large amount of money — of institutions about $2 billion. alive and Without the net worth certificate program, the FDIC would have had considerable difficulty finding buyers for failing savings banks and that would have further increased costs. Aggregate net worth certificate balances started declining 1986 and are now down to $542 million, a decrease of 25 percent. during This year alone, eight savings banks, all of them in New York, have completely prepaid their certificates. Only 14 institutions are still in the program and all of them are now profitable. Hindsight argues that it made good sense to slow down the failure process and exercise forebearance -- just so long as the institutions were not pursuing policies likely to increase the FDIC's ultimate exposure. constraints on what ''assisted" institutions could The FDIC did impose do. Exotic were discouraged as was overly aggressive bidding for deposits. activities Performance was closely monitored through examinations and a review of planning submis sions. The FDIC was undoubtedly helped by several forces: traditional ly, savings bankers were conservative and community oriented; the east coast concentration tended to limit a strong growth orientation; and these same east coast markets proved to be solid and the source of few credit problems. -5- When the cost of funds declined, losses for most of the net worth recipi ents turned to profits. And the institutions, for the most part, were not encumbered by loan quality problems. universal scenario for all thrifts. Unfortunately, that has not been the Attitudes toward taking risk, the economic environment and supervisory policy served to convert an interest rate problem into a loan quality problem in other parts of the country. Some thrifts tried to grow out of the interest rate problem by making high-yield loans to minimize the relative importance of old, low-yielding loans. Not all institutions had the experienced staff to grow rapidly and sound ly. Loan quality deteriorated. The Bank Board, squeezed by pressure from the White House Office of Management and Budget, didn't have the staff to monitor lending practices. Their policies the condition of institutions. cial real estate values has initially did not tie growth to Finally, weakness in energy prices and commer so devastated some economic sectors that even well-screened loans have turned sour. Thus, many thrifts, despite the dramatic decline in rates, are facing enormous difficulties. In large part, it reflects the failure to temper forebearance with appropriate supervisory restraint. Forebearance must also be tempered with judgement. It makes no sense to allow institutions to continue to operate if doing so significantly in creases the institutions. likely ultimate cost to the insurance fund and to competitive Unfortunately, the weakened financial condition of FSLIC pre vents the optimal resolution of such problem institutions. important reason for recapitalizing FSLIC. That is one very 6- - We can all learn from what has happened over the past several We have seen enormous changes in the economic environment. years. During an eight- year period we have seen Treasury bill rates go from six percent to 16 percent and back greater. below six. The percentage swings oil prices have been even Not too long ago, big banks would have done most anything to get into Texas. Who would have thought that New Jersey would become more coveted? We must be ever vigilant for change. the way they are — Never rely too heavily on things staying because they won't! We have seen capital forebearance work — banks in were handled by the FDIC. through the way failing savings Forebearance also helped many S&Ls, but allowed major problems to develop for others. Clearly, a number of factors contributed to the uneven thrift performance. However, I am convinced one important ingredient was the relative level of regulatory oversight of troubled institutions. The only way to check the behavior of high rollers and incompe tents is through good, effective safety surveillance. In today's economy, we see some very weak sectors contributing to severe problems at commercial banks in the southwest and in some of the agricultural midwest. A good case can be made for some degree of capital forebearance, particularly where bank managements are competently doing what they can to lessen their problems. Closing banks precipitously and placing assets in a liquidation mode serves no useful purpose. FDIC costs, place additional banks and bank customers. burden on distressed distressed It is apt to increase markets and hurt other -7- We are doing some things and looking at others that are consistent with the general philosophy, "don't make a bad situation worse." forebearance to operate that program with program that less has been allows than institutions normal limited, capital but in distressed requirements. growing. Also, We have a capital environments Participation examiners more tolerant of banks struggling in depressed economies. have in become Enforcement actions are initiated less eagerly, unless insiders are misbehaving. When banks are closed we encourage acquiring institutions to buy more assets. As you might expect, it is becoming increasingly hard to find acquir ing banks — especially banks who will take on a lot of a failed bank's loans. Understandably, credit potential risk as well as buyers are very apprehensive the drain respects this buyer resistance on their managerial about the potential resources. In some is similar to what we encountered in trying to arrange mergers for savings banks. As was done in those cases, the FDIC may need to assume much of the risk associated with failed bank assets. We have offered risk-sharing arrangements in some purchase and assumption trans actions. Such an approach could reduce our costs. Another altogether. option is to open bank assistance and avoid failure This also keeps distressed assets out of the liquidation mode and can reduce FDIC costs. option. provide However, we envision only limited use of this And only then, when there is clear financial benefit for the FDIC. In addition, the surviving institution must have good future prospects. We - clearly do not want to enhance 8- the position of shareholders and junior creditors of the failing institution, and we want new private sector capital involved. for all We recognize, though, that all objectives cannot always be achieved transactions. Today's to assistance proposals - environment calls for a pragmatic approach one that looks closely at potential benefits and doesn't reject requests automatically. Experience shows that forebearance does not always work. even encourage, failing increased institutions further; remaining risk-taking. alive can franchise add It can allow, It can make things worse. to FDIC costs. value can disappear. Keeping Assets can deteriorate Deterioration can occur more rapidly in distressed commercial banks than in distressed thrifts. I think we need to evaluate each case carefully. in looking at options. What are the We need to be hard nosed Not all decisions will come easily. may sometimes appear arbitrary. lessons of Thus, Our decisions Life isn't always easy. this history for savings banks? Before the interest rate problems hit savings banks, there is little evidence that many managers anticipated that borrowing short and lending long might invite prob lems. or Given the restrictive easy ways of avoiding the regulatory environment, problem. there weren't perfect As I suggested, the FDIC's record on the mismatch problem was not so hot, either. I don't know how interest rates will behave in the future, although I have a feeling that some thrifts may have already forgotten about interest -9- rate risk. will Even a very stable rate environment contains risk. change in other ways. Your markets Regulators are not especially astute at antici pating future problems or opportunities so it's up to you to be prepared. I would urge you to invest some of your growing earnings in the kind of manage ment depth that will strength. help you plan ahead, and contribute to your long-run
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