Each depositor insured to at least $250,000 per insured bank

Insured financial institutions are vulnerable to a variety of risks, including credit, operational, and interest rate risk. For the most part, bank managers and regulators understand the factors and scenarios that may heighten these risks and therefore can develop prudent strategies for minimizing or mitigating a particular institution’s vulnerability. However, risk also may emerge from unexpected sources, such as changes in accounting standards, congressional appropriations, macroeconomic developments and enactment of federal and state laws and regulations. As described in the FDIC Outlook introduction, this exposure can collectively be described as “stroke-of-the-pen” risk, as a single change in policies relating to one area of the economy may bring unanticipated negative consequences for other sectors—including banks and savings institutions.

This article focuses on three historical events that had significant implications for FDIC-insured financial institutions: a 1979 shift in Federal Reserve monetary policy that led to dramatic increases in interest rates; enactment of the Tax Reform Act of 1986; and implementation of Statement of Financial Accounting Standards No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. Although significant debate and deliberation occurred before these changes were enacted, their implications for insured institutions may not have been fully understood at the time. Overall, the effects of these regulatory, legislative, and accounting changes have been positive; however, some specific provisions complicated the operating environment for banks and thrifts.

A Shift in U.S. Monetary Policy
During the late 1970s, the U.S. economy was characterized by high levels of inflation, interest rates, and unemployment, a condition referred to by economists as “stagflation.” While a series of energy price shocks had contributed to rising inflation during the 1970s, by the end of the decade there was also recognition that reforms were needed in the way the Federal Reserve conducted monetary policy.¹ The Federal Reserve’s policy had been to target—or to seek to preserve stability in—the level of short-term interest rates, with the expectation that doing so would stabilize economic activity. However, prices rose and inflationary expectations began to become firmly entrenched in household, business, and investor decisions. The high inflation rate tended to distort the economic decisions made by all of these groups, impairing the overall performance of the economy.

Because of this economic scenario, the Federal Open Market Committee (FOMC), in an historic session held on October 6, 1979, approved a fundamental shift in its monetary policy strategy. The new strategy switched the Federal Reserve’s immediate focus from targeting short-term interest rates to achieving stability in the growth of monetary reserves and, hence, the supply of money. This shift in operating procedure effectively meant that monetary policy would no longer attempt to cushion the blow of economic shocks, such as a sharp rise in oil prices, at the cost of allowing inflation to rise. Instead, the Federal Reserve pursued a longer-term goal of price stability by emphasizing controlled growth in monetary reserves and the money supply.

The shift in policy necessitated an immediate and dramatic rise in U.S. short-term interest rates. The federal funds rate quickly rose from an already high 11.4 percent in September 1979 to 13.8 percent in October, and to 17.2 percent by March 1980.² This change in interest rates was deemed necessary in part to curtail expectations of ever-rising consumer prices, which increased at a year-over-year rate of 11.7 percent in the third quarter of 1979.

In terms of containing inflation, the policy change was considered an unqualified success. The inflation rate peaked at 12.9 percent in the third quarter of 1980. Within three years, consumer price inflation fell to just 2.5 percent.³ But the impact on the U.S. economy was severe. Back-to-back recessions in 1980 and 1981–82 drove the U.S. unemployment rate to a post-Depression high of 10.8 percent by the end of 1982. It was not until September 1987 that the unemployment rate fell to where it had been when the FOMC instituted its October 1979 policy change.

Chart 1

Chart 2

Perhaps less widely appreciated at the time was the effect that high and volatile short-term interest rates would have on financial institutions, particularly thrift institutions insured by the Federal Savings and Loan Insurance Corporation (FSLIC). The predominant business model for thrifts up to that time was to originate and hold long-term, fixed-rate mortgage loans, funding them primarily with savings deposits of somewhat shorter duration. Through most of their history, this basic strategy had produced steady, if unspectacular, earnings results (see Chart 1). The industry’s return on assets averaged 0.62 percent during the 1970s and measured 0.64 percent in 1979. However, by this measure, industry profitability in 1980 declined by four-fifths, to just 13 basis points. The thrift industry as a whole lost $4.6 billion in 1981 and $4.3 billion in 1982.⁴ On a before-tax basis, an additional $1.5 billion a year in losses would have occurred during this period.⁵

The financial problems that began for the thrift industry in 1980 coincided with the sudden spike in interest rates associated with the change in Federal Reserve policy. While the long-term mortgage assets held by thrifts continued to pay steady streams of interest, their market value deteriorated as interest rates rose. Meanwhile, the shorter maturity deposit liabilities used to fund thrift balance sheets were quickly becoming much more expensive. As short-term deposits matured, thrift managers were left with an unenviable choice: to either liquidate their mortgage holdings and realize a capital loss, or fund them with market-rate deposits and incur operating losses as long as rates remained high.⁶ Given its relatively monolithic business model at the time, with its built-in vulnerability to spikes in interest rates, the thrift industry continued to incur losses as long as high interest rates persisted. Chart 2 shows that the average net worth of the thrift industry declined for six consecutive years after 1979, falling by more than half to just 2.7 percent. By 1981 the gap between book value and market value of the thrift industry’s net worth exceeded $86 billion, making the industry as a whole insolvent on a market-value basis.⁷

Legislators, regulators, and thrifts initiated actions in the early 1980s intended to limit or in some cases recoup the losses resulting from the interest rate spike. Congress passed legislation in 1980 to gradually relax the Regulation Q ceilings on deposit interest rates, so that thrifts could offer competitive market rates to attract and retain deposit funding. This move helped to solve one problem for the industry: disintermediation, or the outflow of deposits as savers found higher returns in new instruments (such as money market mutual funds) that paid market rates of return. It did not, however, solve the earnings problems resulting from rising deposit costs and shrinking net interest margins. The thrift industry’s net interest income for 1981 was a negative $1.8 billion (–0.28 percent of assets), which deteriorated to a negative $4.2 billion (–0.61 percent) in 1982.⁸

Although the thrift industry was losing money rapidly, there was the possibility that a decline in interest rates and a steepening of the yield curve could help thrifts become profitable if they occurred soon. A range of forbearance policies enacted by federal bank and thrift regulators in the early 1980s were designed to give the industry extra time to address its financial problems. These policies included a lowering of regulatory net worth requirements, a net worth certificate program that helped undercapitalized financial institutions meet their capital requirements, and adjustments to accounting policies to allow institutions to defer losses into the future.⁹

Legislation enacted in 1982 also allowed thrifts to engage in new types of lending activities that promised to boost asset yields and limit exposures to future interest rate spikes. These new powers included, most notably, the ability to fund commercial real estate (CRE) loans and, under certain conditions, to make equity investments in CRE enterprises. In the generally adverse financial climate facing the thrift industry at that time, a number of institutions significantly expanded their activities in these nontraditional areas. Nonmortgage loans held by FSLIC-insured institutions more than doubled as a percentage of assets between 1982 and 1986, from 3.0 percent to 6.5 percent. But these new investment powers were not a panacea for the industry. While they helped to mitigate the interest-rate risk exposures that had produced the losses of 1980–81, they significantly raised the credit risk profile of many thrifts, leading to even larger problems in the mid- to late 1980s.

A number of studies have documented the roles played by regulatory forbearance and deregulation in contributing to the eventual failure of hundreds of insolvent thrift institutions in the 1980s and early 1990s and the insolvency of the FSLIC itself in 1989.¹⁰ Some studies also emphasize the interest rate squeeze of 1979–1981 as the prime mover of the ultimate thrift industry debacle.¹¹ A prominent role was also played by the economic adversity associated with the energy industry in the Southwest, the defense industry in New England, and the “rolling regional recession” that depressed commercial real estate markets and imposed large losses on banks and thrifts in both regions. Perhaps it is in part the sheer magnitude of these later losses—2,420 federally insured banks and thrifts failed between 1985 and 1993—that tends to overshadow the role played by the initial interest rate shock in pushing the thrift industry toward its later financial problems.

The Tax Reform Act of 1986 (Tax Act)
The 1986 amendment to federal tax laws on real estate investments represents a prime example of how a policy change can affect financial institutions. With the stroke of a pen, this legislation eliminated the ability to offset passive losses with nonpassive income; increased the capital gains tax rate from 20 to 28 percent; and reinstated straight-line depreciation, dampening demand for CRE investment and putting downward pressure on real estate prices. Ultimately, this legislation tended to depress real estate market values in the late 1980s, which in turn contributed to the subsequent failures of financial institutions with relatively large concentrations in real estate development loans.

In some sense, the Economic Recovery Act of 1981 set the stage for enactment of the Tax Act of 1986, as it lowered marginal tax rates and changed the capital gains rules and depreciation schedules for real estate investments. The 1981 Act allowed investors to recoup their initial investment quickly through tax losses alone, which resulted in real estate investments becoming a favored federal tax shelter. The growing popularity of real estate was reflected on financial institutions’ balance sheets. For example, in 1980, commercial bank real estate loans as a percentage of total loans was 18 percent. Five years later, this amount had jumped to 27 percent.

The Tax Act of 1986 wiped out the 1981 tax advantages and made sweeping changes in the treatment of personal and corporate income. (See Table 1 for a comparison of the tax changes made throughout the 1980s.) The legislation eliminated many tax deductions and tax preferences and changed the tax treatment of bad debt reserves and tax-exempt securities. Previously, taxpayers generally could use losses and credits from one activity to offset income from another activity. Following enactment of the Tax Act, taxpayers could not use losses and credits to offset income from another activity; instead, passive losses and credits had to apply to other passive income.¹² CRE now became a relatively higher risk investment because the federal government would no longer share the losses of unsuccessful investments.¹³ Rental real estate income earned by proprietors and partnerships would be treated as corporate income, and be fully taxed if positive. As a result, investors began to ask higher rents on real estate investments to compensate for higher taxes. The after-tax internal rate of return declined under the Tax Act; much of the difference can be attributed to the elimination of depreciation deductions that had been allowed under the 1981 tax bill.

Table 1

Overall, the 1986 tax legislation tended to depress real estate values because of changes in the depreciation schedule. Under the depreciation provisions in the 1981 tax law, the after-tax return of CRE investments had increased relative to other assets. The Tax Act of 1986 eliminated this favorable depreciation schedule. As a result, demand for real estate declined and the value of real estate fell. According to the FDIC’s History of the Eighties, Lessons for the Future, $16 billion was invested in real estate limited partnerships in 1985; by 1989, this amount had declined to $1.5 billion. In addition, the quality of banks’ real estate loans deteriorated, with nonperforming loans rising from 3.1 percent in 1984 to 4.8 percent in 1990 (see Table 2). The 1980s ended with a two-year total of 406 failed banks that held $64.9 billion in assets.¹⁴ Real estate losses contributed significantly to these bank failures, costing the FDIC billions of dollars in resolution costs and leading to the FDIC’s first annual operating loss. The FDIC and the Resolution Trust Corporation eventually became the nation’s largest real estate sales organizations because of the inventories acquired from failed banks and thrifts in areas where real estate values fell precipitously.¹⁵ To be sure, changes in the tax laws were not the only—and were perhaps not the primary—cause of the bank and thrift losses in CRE loans in the late 1980s and early 1990s. However, the changes were a well documented contributing factor. This situation shows clearly the effects of a stroke-of-the-pen legislative policy change, and reinforces the need for bank management to closely monitor all implications of key tax legislation.

Table 2

Statement of Financial Accounting Standards No. 125—Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities¹⁶
In 1996, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 125 (FAS 125) to provide guidance for distinguishing between the transfers of financial assets that should be reported as sales and transfers that should be reported as borrowings. During the early 1990s, the FASB acknowledged that the market’s increasingly complicated financial assets made it difficult to determine when transferred financial assets should be removed from the balance sheet and a related gain or loss recognized, and announced efforts to develop plans for an approach that would achieve consistent, credible, and understandable financial statements.

The FASB recognized that financial assets and liabilities can be divided into several categories, such as servicing rights, residual interests, recourse obligations, and pledges of collateral. When accounting for transfers of financial assets, particularly those related to securitizations of assets, concerns arose about whether transactions represented a sale, which would result in the reporting of a gain or loss on sale, or a secured borrowing. Unless accounted for correctly, securitizing assets can make companies appear more profitable than they are and overstate capital levels, while the risks that are often concentrated in the interests that an entity retains in the securitized assets may not have been properly considered in the measurement process. In another stroke-of-the-pen policy change, FAS 125 required that the fair values of retained interests enter into the accounting for securitizations that qualified as sales, thereby affecting the size of the gain or loss on the sale. In the absence of quoted market prices, which was typically the case with retained interests, companies had to estimate the fair value of these interests and support the estimated fair value with documentation using reasonable and supportable assumptions.

FAS 125 proved to be quite complicated, and it became clear that more guidance was needed. In September 1998, December 1998, and July 1999, the FASB issued “Question and Answer” implementation guidance on FAS 125. In addition, in December 1999, the federal bank regulatory agencies issued the Interagency Guidance on Asset Securitization Activities, which included discussion of valuations of retained interests in securitizations accounted for in accordance with FAS 125. The interagency guidance emphasized the agencies’ expectation that retained interests held as assets would be supported by documentation of the interests’ fair values, using reasonable, conservative valuation assumptions that could be objectively verified.

The pitfalls of inaccurately accounting for securitized assets were obvious in the situation of Superior Bank FSB.¹⁷ Starting in 1993, Superior Bank originated and securitized large volumes of subprime residential mortgages and retained residual assets that were a by-product of the securitizations. Residual interests represent claims on the cash flows that remain after all obligations to investors and any related expenses have been satisfied.¹⁸ In 1994, Superior expanded its securitizations activities to incorporate subprime automobile lending. Superior’s concentrations of residual assets to tangible capital rose from 122 percent at year-end 1995 to 268 percent at year-end 1999.

Because there was not a ready market for these assets, Superior valued its residual interests using a model. The model was based on the thrift’s assumptions of default rates and prepayment rates on the portfolio of loans underlying the securitizations and discount rates.¹⁹ According to the FDIC Office of Inspector General’s report on the failure of Superior, the thrift booked large imputed gains based on liberal interpretations of FAS 125.²⁰ For example, the thrift used unsupported discount rates, and at one point lowered the discount rate by 400 basis points, resulting in a substantial gain. Superior also chose a method of accounting that did not require discounting of funds providing credit enhancement to securitizations, even though those funds were not immediately available to the thrift.²¹ The large imputed gains augmented capital and allowed the thrift to continue to lend and securitize.

In 2000, regulators noticed that, although some institutions had shown downward adjustments to reflect the application of the guidance in the 1998 FASB Questions and Answers, Superior’s financial data did not have such adjustments.²² The Office of Thrift Supervision, with FDIC participation, scheduled an on-site visitation in October 2000 to review residual assumptions, and the agencies focused on residuals at a subsequent examination in March 2001. After examiners found the thrift had not properly discounted cash flows and had used other unsupported assumptions, they determined that the thrift’s assets were overvalued by at least $420 million as of December 31, 2000.²³

When federal regulators required Superior Bank to restate its financial data, the institution was deemed significantly undercapitalized and failed shortly thereafter. At the time of its failure, Superior had $1.7 billion in total assets, of which $842 million were residual assets. The failure cost to the FDIC was an estimated $426 million.

Lessons Learned
The business strategies, investment choices, and risk management decisions of financial institutions are necessarily based on the current economic, accounting, legislative, and regulatory situation, as well as the possibility that this situation may change. However, management can never anticipate all scenarios or the unintended negative consequences that could arise from sweeping policy changes.

The three historical “stroke-of-the-pen” events addressed in this article show the dramatic effects policy changes can sometimes exert on the operating environment of financial institutions. The 1979 shift in U.S. monetary policy was successful in containing inflation and contributed to much improved U.S. economic performance in the 1980s and 1990s. But at the time it was introduced, the full effects of this policy change, in tandem with other domestic and international economic events, were difficult, if not impossible, for financial institution managers and regulators to anticipate. Similarly, the changes mandated by the Tax Reform Act of 1986 brought about significant adverse consequences for insured financial institutions with exposure to CRE loans. The elimination or tightening of real estate tax deductions and preferences contributed to a serious downturn in the CRE market and eventually to failures of insured financial institutions with relatively high CRE portfolio concentrations. Finally, the accounting changes of FAS 125, although developed and implemented to improve the clarity, consistency, and transparency of financial statements, had the unintended effect of potentially complicating accounting procedures for securitized assets, as the example of Superior Bank demonstrates.

The point of emphasizing these episodes of systemic, “stroke-of-the-pen” risk is not to portray them as unmanageable, catastrophic events. As with any other class of risks, bank managers assume ultimate responsibility for monitoring changes in the policy environment and managing their institutions’ exposure to these changes. The point is for risk managers to attempt to anticipate the possible consequences of policy changes as early as possible, and to recognize the possibility that such changes may have sweeping effects on their institutions. These episodes show that, despite substantial debate and discussion before the fact, the enactment of policy changes may have unforeseen effects on financial operations, and their negative results can be considerable. While every implication of a policy change cannot be known in advance, management is best served by a business strategy that is watchful for and responsive to such changes.

Suggested Readings
Axilrod, Stephen H. 1985. U.S. Monetary Policy in Recent Years: An Overview. Federal Reserve Bulletin, 71:14-24.

Benston, George J. 1985. An Analysis of the Causes of Savings and Loan Association Failures. Salomon Brothers Center for the Study of Financial Institutions Monograph Series in Finance and Economics, 4/5.

Federal Deposit Insurance Corporation (FDIC). 1982. Annual Report of the FDIC for the Year Ended December 31, 1982. FDIC.

Federal Reserve Bank of St. Louis. 2005. Conference Proceedings: Reflections on Monetary Policy 25 Years After October 1979. FRBSTL Review 87. March/April 2:137-358.

Follain, James R., Patric H. Hendershott, and David C. Ling. 1987. Understanding the Real Estate Provisions of Tax Reform: Motivation and Impact. National Tax Journal 40, 3:363-372.

Johnson, Christian A. 2004. The Failure of Superior Bank FSB: Regulatory Lessons Learned. Banking Law Journal 121, 47:1-13.

Neuberger, Jonathan A. 1988. Tax Reform and Bank Behavior. Federal Reserve Bank of San Francisco Weekly Letter December 16, 1-3.

Seballows, Lynn D., and James B. Thomson. 1990. Underlying Causes of Commercial Bank Failures in the 1980s. Federal Reserve Bank of Cleveland Economic Commentary September 1, 1-4.

U.S. General Accounting Office. Bank Regulation: Analysis of the Failure of Superior Bank, FSB, Hinsdale, Illinois. GAO/02-419T. February 7, 2002.

Volcker, Paul A. 1981. Statement before the Committee on Banking, Housing, and Urban Affairs. Federal Reserve Bulletin, 67:237-241.

Richard A. Brown, Chief Economist
Jane F. Coburn, Senior Financial Analyst
Christopher J. Newbury, Chief, Financial Analysis Section