As the Chairman said in his opening remarks, on September 11, 1986, the Board adopted a proposal to extend the direct investment regulation for two more years.

The Board based its decision to extend the rule on its supervisory experience and on the results of the study conducted by OPER. The OPER study showed that the level of direct investments by failed institutions is positively related to the FSLIC's case resolution cost.

More specifically, the study showed that direct investments by failed institutions increases FSLIC cost between 60 to 85 cents for each additional dollar of direct investment.

MR. WHITE: Excuse me. Are we going to get into greater detail?

This is my first meeting.

MS. GATTUSO: Greater detail of comments? Yes.

MR. WHITE: We will get into greater detail. Thank you.

MS. GATTUSO: The comment period on the proposal extended from September 17, 1986, until October 17, 1986. The Board received 83 public comments in response to the proposal 45 from insured institutions, seven by industry trade associations, five by law firms representing insured institutions, three by economic consultants representing insured institutions, and 23 from Members of Congress.

Six of the comments supported the proposal to extend the rule for two years. Three comments supported the proposal with certain suggested modifications, 28 requested an extension of the comment period, and 32 members of the Federal Home Loan Bank System petitioned for a hearing on the proposal.

The comments generally raised four issues concerning the proposal. One being the Board's statutory authority to adopt the rule; the economic and factual basis for the rule; available alternatives to the rule; and procedural issues, such as the length of the comment period, and the petitions for public hearings.

I will summarize the comments, the issues raised by the comments, and then Bob Sahadi from OPER will discuss the Board's studies on this issue.

With respect to statutory authority to adopt the proposal, several commenters contended that the Board has no statutory authority to extend a regulation that preempts the enactments of state legislatures authorizing unlimited or less restrictive direct investment by insured institutions.

Additionally, these comments argue that the proposal is a direct contravention of congressional purpose in creating a dual banking system.

Commenters also argued that the proposal is unsupported by the OPER study. Several commenters argued that the OPER study is of no value in measuring the correlation between direct investments and institution failure because the study did not address healthy or non-failed institutions.

One commenter asserted that the OPER study was biased because the actual cost to the FSLIC of the failures studied is the FSLIC's estimate of cost based on its valuation of the assets and liabilities of failed institutions.

Another commenter asserted that the OPER study showed a positive relationship between FSLIC cost and the period of time that passes before the Board acts to close an insolvent institution. This commenter argued that there is an interrelationship between the time an insolvent thrift is allowed to operate and the level and quality of its direct investments; therefore, they concluded that the real problem is lack of prompt action on the part of the FSLIC to close these institutions and not direct investments.

Several commenters also asserted that direct investments are necessary to the financial well-being of insured institutions and the thrift industry. One commenter contended that the risks presented by direct investments are less serious than the risks that will continue to confront both the thrift industry and the FSLIC if insured institutions are constrained in their efforts to use direct investments to cure their present financial problems.

Several commenters asserted that the Board's reliance on its supervisory experience is misplaced and does not show that increased direct investments are linked to institution failure.

One commenter contended that the supervisory experience on which the Board relies is based more on examples of institutions which have failed due to fraud and mismanagement.

In the proposal, the Board specifically solicited comments on the administrative flexibility of the direct investment rule. Several commenters argued that the waiver provision found in the rule is ineffective. They asserted that the time delays involved in receiving preapproval in the filing process is costly to thrifts.

They also contended that the value of a direct investment depends on the time when the investment is made and, to require an institution to waft up to 30 days before they can make the investment, will deprive them of promising investment opportunities.

Several commenters also argued that there's no need for direct investment in light of increased net worth requirements with the new regulatory capital rule.

The new capital rule, which will be effective on January 1, 1987, requires all insured institutions and federally-chartered thrifts to maintain at the end of the phase-in period regulatory capital equal to 6 percent of total liabilities, plus added capital based on a contingency component, less the maturity matching credit.

Several commenters suggested that the Board modify the direct investment limits in light of the new capital rule.

Two suggested that the Board raise the 10 percent direct investment threshold to 15 percent for those institutions that are in compliance with their new minimal capital requirements.

In addition, these commenters suggested that the Board only extend the rule for a one-year period as opposed to a two-year period.

Other commenters suggested modifying the rule to permit unlimited direct investments for insured institutions whose regulatory capital exceeds 6 percent to provide a 20 percent threshold for those institutions meeting the increased regulatory capital requirements.

This commenter also suggested that, with respect to institutions that meet their current regulatory capital requirements, the rule should be modified to allow them to make direct investments up to 10 percent without supervisory intervention; from 10 to 20 percent upon notice to the PSA; and above 20 percent only with supervisory approval.

These commenters suggested that the Board continue to require prior supervisory approval for direct investments above 10 percent for those institutions that do not meet the regulatory capital requirements.

With respect to procedural issues, several commenters asserted that the comment period following publication of the proposal was inadequate and requested various extensions of the comment period.

The comment period ran for 30 days. The length of the comment period was consistent with the APA [Administrative Procedures Act], which does not require any specific time period for public comment.

As I indicated earlier, the Board received and considered 83

public comments, and many of those were late received.

MR. GRAY: Many of them were late received?

MS. GATTUSO: [Ms. Gattuso nodded her head, indicating an affirmative response.] As mentioned earlier, too, the Board has received petitions from 32 members of the Federal Home Loan Bank System requesting a hearing on the proposal pursuant to 12 CFR 507.10 That section provides, after receipt of written requests therefor to the Secretary of the Board of at least 25 members of the Federal Home Loan Bank System, the Board will fix a time and a place for a hearing on a proposed amendment or upon an expiring regulation relating to Federal Home Loan Banks to which petitioners object.

The staff has reviewed the history of Section 507.10, and has concluded that the section does not apply to a regulation such as the Direct Investment Regulation, which primarily regulates investment activities of insured institutions. It applies only to those proposed amendments and existing regulations whose primary function it is to regulate the activities and operations of the Federal Home Loan Banks.

The staff notes, however, that such a hearing is discretionary is in the Board's discretion--if they would like to hold such a hearing, but they are not required to do so under 507.10. And they're also not required to do so under the APA.

That concludes my summary of comments, and Bob Sahadi now will discuss OPER's studies.

MR. GRAY: Before you go ahead, how many of the comments came from insured institutions?

MR. SAHADI: Good afternoon, ladies and gentlemen.

I have at my left here Mr. Don Bisenfus, who is a senior staff economist, who has participated from a technical aspect in many of these studies. He'11 first lead us through the study, that the Board is proposing, the most justification for this reg, that which leads to the 60 to 85 cent cost to the FSLIC in case of direct investments in insolvent institutions.

MR. BISENIUS: The study was undertaken by three co-authors, Jim Barth of George Washington University, at that time a visiting scholar in the Office of Policy and Economic Research; Dan Brumbaugh who, at that time, was with the staff of OPER; and Dan Sauerhaft .

The study was entitled "Failure Cost of Government Regulated Financial Firms, the Case of Thrift Institutions."

The study sought to analyze thrift failure over the last four years, to see whether or not a set of balance sheet ratios and other relevant variables could be used to explain, or at least derive, associations with FSLIC's costs.

The study looked at 324 failures that occurred during the time period. That included those that actually cost FSLIC money and those institutions which failed or where a supervisory merger was arranged, but no actual outlay from FSLIC took place.

I guess the relevant result, or at least one of the results, of the study applicable to this regulation was that the higher levels of direct investment in failed institutions were statistically significantly related to cost for FSLIC. Of course, figures on those variables, again, ranged, depending on the specification, between 60 and 85 cents, suggesting that for each additional dollar of direct investment in a failed institution, the cost of FSLIC was anywhere between 60 and 85 cents.

Other significant variables included the acquisition and development of land loans, and also a variable which measured the delay, or the delay in response, between the time an institution became insolvent and the time of its closure by the FSLIC. And that variable was found to increase FSLIC's cost---any delay in action.

That's the primary results of the study at this point.

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MR. WHITE: Well, if there's a flow I don't want to get in the way of a flow -- but I do have some questions that I would like to ask.

MR. GRAY: Okay. Why don't you go ahead now.

MR. WHITE: All right. As you probably know, among the comments, or the commenters that we received in this record, a number has suggested that your study, that you just described, suffers from what a statistician would call selection bias--that basically all you've done is looked at the failed institutions, and arguably you've failed to also note, if this is the case, that direct investments might have benefitted other institutions, preventing them from failing. And, therefore, perhaps the net cost to FSLİC is not negative but, in fact, when you look at this larger group of both successful and failed institutions, that the net cost might be zero, might be positive, might be less negative, but you can't tell that from just looking at the failed institutions alone.

Would you care to comment on that?

MR. BISENIUS: I think it's an accurate summary of, in fact, what the study seeks to do, and that is, the study, by definition, was limited to analyze the cost to FSLIC of a failure. It did not try to analyze the effect of direct investment in healthy institutions.

So, again, if that's a criticism of the study, I don't think it should be; I don't think you mean it that way. That defines the scope of the study. Obviously, there's no cost in a failed institution per se and, therefore, this study was not capable of analyzing that issue.

To my knowledge, I don't believe there is a study that provides the evidence that you suggest, and that is the positive benefits of direct investment, or the reduction in the likelihood of failure and the reduction, therefore, in potential cost to the FSLIC, such that a net benefit number