The Debacle That Buried Washington
By STEPHEN LABATON
ASHINGTON -- It's alive! The savings and loan debacle, which has cost taxpayers $165
billion, is about to become more expensive.
That may come as a surprise to those who thought the costliest bailout in American history was long
completed, as much a ghost of the 80s as Rubik's cubes, break dancing or perestroika.
But two years ago, the Supreme Court ruled that the government had betrayed investors by
changing the rules of the bailout at the height of the savings and loan crisis. And now, a little-known
federal court here is getting ready to begin assessing the costs -- a sum that could add up to
anywhere from $4 billion to $50 billion, depending on which side is guessing.
In the first big test case, the chief JUdge of the United States Court of Federal Claims is expected to
decide by year-end the size of the award to a California savings and loan that nearly collapsed after
federal accounting rules were changed in 1989.
The judge, Loren A. Smith, has already indicated that he will order a sizable judgment for the
savings and loan, Glendale Federal Bank, which is seeking $1.9 billion.
That could set a standard for a parade of cases -- the first of more than 120 brought by existing and
moribund savings associations and by shareholders -- that are set for trial over the next few months.
The exact size of the awards is likely to be determined by appeals courts. But this much is certain:
Whatever the tab, taxpayers will pay it, thanks to a two-paragraph provision that lawmakers buried
in last month's appropriations legislation at the behest of savings and loan lobbyists, who feared
either that the government would not pay or that the industry might end up being saddled with the
costs.
Administration officials, who supported the move, calculate that every $1 billion awarded to the
industry will cost each American household $10. And as awards against the government mount,
decade-old questions about Washington's willingness and ability to tackle the savings industry's
problems are certain to be revived.
Illustrating their importance and complexity, the savings and loan cases have engaged legions of
lawyers -- the Justice Department is devoting more resources to them than to any other matter,
including the Microsoft antitrust case. Some unusual battle lines have been drawn: Two federal
agencies are on opposing sides, and two Nobel Prize-winning economists have been pitted against
each other on the meaning of their own collaborative work. In the end, huge payouts may go to
some of the nation's wealthiest and most aggressive financiers.
In the 1980s, after loosened lending rules and a real estate collapse left many savings associations
buried in bad loans, regulators decided that the cheapest way to heal the lenders was to encourage
them to merge with healthier institutions or find new investors.
So regulators struck deals with, among others, Ronald O. Perelman, who had bought Revlon with
junk bonds; the Bass family of Texas; Jay A. Pritzker, whose family controls Hyatt hotels, among
other properties; Lewis Ranieri, the investment banker credited with inventing mortgage-backed
securities, and William E. Simon, the former Treasury secretary.
Later, many of the deals were criticized in Congress as being overly generous. But regulators said
that they had no choice, because Congress had refused to provide money to back the insured
deposits of the rapidly growing list of hemorrhaging institutions.
Now these investors and others who still own shares in the savings and loans stand to gain from the
damage claims. That -- and the possibility that current and former savings executives may reap big
gains -- would be a remarkable end to a financial calamity that once stigmatized the industry as a
haven for incompetent managers and financial scoundrels.
"In 1989, there was no way these people would be paid," said Robert E. Litan of the Brookings
Institution. "The political environment was terrible for them. Now they're no longer demonized. This
was like the appendix of a lot of the deals of the 1980s. Now the appendix has burst and someone's
got to fix it."
The precedent that made such awards possible is known as the Winstar case, named after the
consolidation of suits brought by the Winstar Corp., the Statesman Group and Glendale Federal. In
July 1996, a splintered Supreme Court ruled that the 1989 legislation that rescued the savings and
loan industry also broke the contracts that the institutions' salvagers had made with Washington.
Those contracts, aimed at attracting investors, had given the savings and loans permission to use an
unusual accounting rule that had the effect of letting many institutions satisfy their capital
requirements by booking huge liabilities as assets.
The rule allowed the buyers of weakened institutions to take the difference between their purchase
price and the market value of the institution and count that as an asset, calling it "supervisory
goodwill." Since the price often consisted of the assumption of the insolvent institution's liabilities, the
move converted liabilities into capital that could satisfy regulatory requirements.
The ability to use such accounting led new investors and other savings associations to infuse new
capital into the weaker savings and loans. The rule, however, was heavily criticized by some experts
as a gimmick destined to lead to greater bailout costs some day.
A federal appeals judge ultimately referred to supervisory goodwill as "a euphemism for spinning
straw into gold."
As the savings and loan crisis reached a fever pitch in 1989, the accounting arrangement was
phased out by tough legislation endorsed by President George Bush and approved by lawmakers.
Overnight, the law's provision ending supervisory goodwill turned what had appeared to be healthy
balance sheets into ones that could not meet minimum capital requirements. Many institutions
collapsed. Others tottered on the edge of failure or were bought by healthier companies, resulting in
further consolidation.
And the industry soon unleashed its barrage of lawsuits, essentially accusing Washington of having
perpetrated an enormous bait-and-switch.
In its 1996 ruling, a controlling plurality of the Supreme Court essentially agreed. Justice David H.
Souter dismissed the Clinton administration's arguments that the contracts did not provide insurance
against a legislative change.
"It would, indeed, have been madness," Souter wrote, for the industry to have entered into the
contracts without some guarantee that they were enforceable, "for the very existence of their
institutions would then have been in jeopardy from the moment their agreements were signed."
The ruling breathed new life into the savings and loan lawsuits, which were sent back to the claims
court to set damages and resolve other issues. Since the decision, the Justice Department has quietly
offered settlements of hundreds of millions of dollars to some institutions. But the companies are
waiting to see whether Smith and his colleagues will be more generous.
The industry's lawyers, along with Smith, have criticized the Justice Department as moving slowly in
settling the claims. They have accused government lawyers of dragging their feet and re-arguing
issues that they say were resolved years ago.
"In many respects the Justice Department's positions have been frivolous and served only to delay
progress in these cases and add enormously to the expense," said Charles J. Cooper, a former
senior Justice official whose law firm represents more than a dozen savings associations and former
owners of savings and loans. "It's deepened the uncompensated damages that American citizens are
suffering as a direct breach of their contracts."
In response, the Justice Department has challenged the damage claims as pie-in-the-sky figures that
have no basis in contract law. Its sharpest attacks are aimed at perhaps the suits' most costly
assertions -- that companies like Glendale Federal are entitled to recover all the profits they would
have made if the rules had not changed.
"This is real money," said Frank W. Hunger, the assistant attorney general in charge of the Justice
Department's civil division. "And it's not money that is being sought for anything productive, like
education, housing or the Peace Corps. We're simply not going to pay out billions of taxpayer
dollars when there are bona fide legal issues involved."
The Justice Department is devoting an extraordinary amount of resources to the cases. Some 40
lawyers and a support staff of dozens more have been working full time with an annual budget of
$60 million, nearly half the civil division's total.
The plaintiffs, too, have been spending freely. For instance, Glendale Federal, a unit of Golden State
Bancorp, has used two law firms and spent more than $43 million on its case since 1996, according
to company records on file at the Securities and Exchange Commission.
Because more than 40 of the institutions suing the government are insolvent, the Federal Deposit
Insurance Corp. has also entered the fray, assigning about three dozen of its lawyers to intervene in
the cases. Like a dog chasing its tail, the government now has one agency, the Justice Department,
as a defendant, and another -- the FDIC -- aligned with the plaintiffs in many cases.
The Justice Department has asserted that the FDIC, which also administers a fund from which some
of the judgments may be paid, cannot in effect make claims on itself. "It is a fundamental axiom that
the United States cannot sue itself," the Justice Department said in a brief.
The FDIC has replied that it must pursue the cases because of its legal obligations as a receiver,
representing the institutions that collapsed. The agency's lawyers are concerned that if they fail to
intervene, the agency could be liable to shareholders and creditors. But as a practical matter, much
of what it hopes to recover will result in the simple shift of money from one government account to
another.
The interagency warfare is just one of the strange battles these cases have spawned. In another
notable conflict, two Nobel Prize-winning collaborators have disagreed on whether their shared
work applies to the litigation.
Professor Merton H. Miller of the University of Chicago, who won the Nobel in 1990, testified for
the government that the Modigliani-Miller Theorem, or M&M Propositions, which are the
foundation of modern corporate finance, demonstrated that the industry's claims were wildly
overstated. He said that under the theory, the reduction of supervisory goodwill did not reduce the
value of a savings association and that the profitability of the company did not depend on its level of
goodwill.
"When you phase out goodwill, you're are not taking away any earning asset," Miller testified as a
$1,000-an-hour Justice Department expert. "You are not taking away anything but accounting
smoke and mirrors."
In a lawsuit filed by Glendale's sister institution, California Federal Bank, the industry responded
with its own $1,000-an-hour expert: Professor Franco Modigliani of the Massachusetts Institute of
Technology, the other "M" in the propositions, who won the Nobel in 1985.
"I have decided to testify in this case because my name is associated with the M&M Propositions,
and, in my view, they are being misused by the government in a way that I regard as damaging to
the credibility of the theorem," Modigliani wrote in his expert report. "The truth is that the M&M
Propositions are completely irrelevant to the present issue and have been dragged in as a red
herring."
At ground zero in the cases is Loren Allan Smith, 53, the judge who eight years ago wrote the first
opinion in the Winstar case that gave the industry hope that it could ultimately recover what it had
lost in the 1989 legislation. Not only will he decide the award for Glendale; he has also been issuing
significant rulings on the common issues in the 120-plus cases and has begun to assign some of the
dozen cases to be tried, beginning next month. Then the next batch of 30 lawsuits will be tried.
Smith, an amateur magician and former host of the radio talk show "What's Best for America?,"
entered Washington political circles as a young lawyer working on President Richard Nixon's legal
team during Watergate. Later, he was chief counsel to Ronald Reagan's 1976 and 1980 presidential
campaigns.
In 1985, Reagan appointed him to the Court of Federal Claims, a specialized branch of the judiciary
that hears disputes between the government and its contractors as well as claims against the United
States.
The judge has earned a reputation as a leading proponent of the legal proposition that property
owners should be compensated for the costs they incur under federal regulations. He has rattled the
Justice Department, lambasting its legal maneuverings and suggesting that he is leaning toward a
substantial award to Glendale.
In his seventh-floor office at the claims court, across Lafayette Park from the White House, the
judge said in a recent interview that his job was to dispense justice, not to protect the public
Treasury.
"I see as much a problem to giving away $1 that isn't deserved as to give away $100 billion that was
deserved," he said. "If it's the law, so be it. You've got to follow the law whatever the
consequences. It's not the duty of the judiciary to guard the fisc. A judge's duty is to apply the law
fairly."
But Smith will not have the last word. Whichever side loses is certain to appeal. And another judge
about to hear a savings and loan case has already limited the possible damage claims of a major
plaintiff.
Two weeks ago, in a significant claims court victory for the government, Judge Robert H. Hodges
Jr. ruled that when California federal's case goes to trial on Dec. 12, it cannot pursue the claim that
it is entitled to collect damages equal to the profits it would have earned had it been able to continue
counting supervisory goodwill. Hodges called such a theory "particularly speculative."
For taxpayers, the crucial turn in the cases came late last month in Congress. With no debate and no
news coverage, lawmakers decided that taxpayers, not the industry, would have to finance the
judgments from all the cases. And rather than confront large and politically unpopular damage
awards as they are handed down, legislators also decided to simply keep the spigot to the Treasury
open indefinitely.
Buried in the appropriations legislation that covers all federal spending for the new fiscal year,
lawmakers inserted two paragraphs giving the administration the authority to spend "such sums as
may be necessary." As part of a tangled compromise, the provision was supported by the White
House and by savings lobbyists, who had feared that either the industry might be levied higher
deposit insurance premiums to cover the cases or that the plaintiffs would not be able to collect on
judgments because Congress had not set aside money for such awards.
The administration also prevailed on Congress to leave uncapped all spending to defend the
lawsuits. Some industry lobbyists had sought to limit spending or require more oversight by
Congress, hoping to prod the administration into quickly resolving more of the suits.
With the cases now headed for trial, the beginning of the end is finally at hand for the savings and
loan debacle. But other industries are looking for ways to make use of the precedent that the
government may be liable for costs incurred when it changes its rules.
Lawyers representing electric utilities, telecommunications companies and developers of low-income
housing have begun filing lawsuits, and health care lawyers say they may be next. Initial successes
indicate that taxpayers may end up facing yet more bills.
Three weeks ago, a federal claims judge, citing the Winstar precedent, ruled that the Department of
Energy violated a commitment to remove used radioactive fuel from a nuclear power plant owned
by the Yankee Atomic Electric Co. In all, utilities have pending claims of an estimated $50 billion.
"There are a lot of lawyers who are now trying to shake the money tree," said Joshua I. Schwartz, a
professor of law and co-director of the government procurement program at the George
Washington University Law School." |
