MR. GRAY: What was the rate of return on these? I had -- in the speech I made, a negative 408 base points.

MR. SAHADI: That's correct..

Finally, three of these 21 institutions referred to have been closed by the FSLIC. These three institutions had assets of $703 million, and the cost of resolution to FSLIC is approximately $350 million.

MR. GRAY: And the negative return on assets for those at the time of closure was a negative 916 base points?

MR. SAHADI: That's correct.

In June 1986, the other 16 institutions in the study had an average positive return on assets of 30 basis points, far below the average return on assets of 108 basis points, for the close to 80 percent of the thrift institutions that are healthy today.

Now, some commenters have argued that the problems that were picking up in the direct investment reg are really a function of distressed regional economies. But we decided to do another study that would look at California -- I'm sorry -- did you have something?

MR. WHITE: Well, let me ask it now and if you want to come back to us later, that's just fine.

MR. GRAY: All right. Go ahead.

MR. WHITE: Do we know whether it is the direct investments that pulled these thrifts down? Or stating it another way, did the direct investments perform appreciably worse than the other assets in these institutions' portfolios in the slide down as described?

MR. SAHADI: We have looked at case studies of these institutions, and we find that the direct investments, indeed, in these institutions were sour. There was also land loans that had also soured. But, in many cases, our accountants felt that these were misclassified direct investments.

MR. WHITE: Yeah. But were they the only things that soured? Did the rest of the portfolio sour as well?

MR. SAHADI: There was other, you know, assets of things that soured. It's hard to -- you know, obviously there was overwhelming evidence of direct investment. There were other things that had soured. We haven't broke that out statistically. But that's something that will be forthcoming.

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MR. GRAY: Now, let me understand. You're saying that for these 37 institutions, 21 of which have either been closed or in the FSLIC caseload, or projected to be insolvent within a year. You're saying that I believe --did I hear you say, because I recall this myself, they will cost the FSLIC about $3.5 billion to resolve just 21 institutions?

MR. SAHADI: Yes.

MR. GRAY: That's 21 institutions. And, of course, $3.5 billion is $1.3 billion more than we have today in the FSLIC fund, the primary reserve to the fund.

MR. HENKEL: Let me ask another question, following along on Larry's question.

We're talking about these 37 institutions, 35 of which went in Professor Benston's study.

I quote from a letter that he sent to the Secretary a few weeks ago studying the same group, and all of this doesn't square to me, and I'm just confused.

He said he found the following: One, direct investments are not responsible for any of the three failed S&LAs in the study.

Two, direct investments appear to have contributed to three of the ?? S&LAS that were FSLIC cases. The extent of the losses incurred, however, were importantly mitigated by direct investment profits at one of the other FSLIC cases at the least.

Three, only one of the eight significant supervisory cases appeared to have become distressed because of direct investments, while the financial condition of the six others was significantly helped by profits from direct investments. Thus, a closer view of the past and present, to December '85, operations of the 21 institutions reveals that their problems were largely a result of factors other than direct investments. Indeed, on the whole, direct investments appear to have mitigated losses from other operations.

What do you say to that?

MR. SAHADI: Well, it's our evidence that these institutions he's referring to were not a member of that group of 37 institutions. This is some material that's dated and from a previous study.

MR. HENKEL: I was understanding he was commenting on the same 37 you were talking about.

MR. SAHADI: We can't verify that that's the case.

I'd like to have Frank Passarelli, who's our Senior Policy Advisor in our Office of Regulatory Policy, maybe give us a little feel for some of the cases that we've seen involving direct investments.

MR. PASSARELLI: You can proceed and I'll get this later.

MR. SAHADI: Okay. Let me go through our California study which

MR. BLACK: Let me take a brief stab.

What Professor Benston has done in the past with similar analyses has used reported book returns on direct investment. And the Board supervisory experience, particularly with these kinds of problems or failed shops is that those reported book returns on direct investment are completely unreliable; that they disguise the loss in asset value that is dramatic. And as you've seen from our failure study, isn't just material, it is gigantic, the typical loss on these assets.

So he looks at book returns by problem shops which are unreliable and ignores the loss in the asset value. I mean, I understand why he does it in terms of data available to him, but he should -- I mean, the limits on that form of analysis have to be recognized as well.

I can also add something to your question, Professor White, about are there other things at these institutions -- Board Member White, Dr. White that could be involved. And certainly there is some answer to that.

But it comes back to how this all started. I mean, the Board didn't pick this group of 34 or seven to look at. Professor Benston picked this group. And he, originally back in December of '84, said, "Look, Board, you should not adopt a direct investment rule, because look at these 34 institutions. They're doing much better because of their direct investments. This is the success story."

The Board, in January of '85, in its preamble, wrote the following: The McKenzie Study demonstrates, however, that in the relatively small group of institutions currently engaged in direct investments in excess of 10 percent of their assets, which is the group of 34, they are in fact generally operating in a very risky manner.

For example, compared to the industry as a whole, such institutions have approximately four times as much of their assets in ADC loans, three times as much of their assets in construction loans, twice as many jumbo

deopsits, eight times as many brokered deposits, and grew on the average by 181 percent between mid-'83 and mid-'84, which was almost nine times the average rate of growth. It tells you a couple of things.

It tells you that they were plungers; in general. It tells you, yes, there are other types of investments, and other types of investments that are risk involved. And it also tells you again, in light of our supervisory experience, that they had a great deal of misclassified ADC loans, but some of them were ADC loans. And ADC loans are risky, too.

MR. WHITE: Let me just follow up on one thing that you mentioned two minutes ago.

My brief association with this industry and its problems had led me to believe that if there were hanky-panky occurring in the way that institutions felt with things like fees, that it mostly happened, particularly back in the period that the studies cover, on the ADC loan side, and less so on the direct investment.

MR. BLACK: You're clearly correct in an ordinal sense. That doesn't mean that there wasn't some significant hanky-panky on the direct investment side with when you booked profits. And you have to also remember the interplay. It was very frequent to do some of that stuff where you did ADC loan in connection with the direct investment. You sell part of the project where you provide financing. You book the profits from the sale of that portion of your development, but you've really given 120 percent financing. There are many ways.

But you're right. More of the games were played on the ADC side.

MR. HENKEL: Let me make sure that you understand.

I'm not saying that any particular academic is right or wrong. I've never met Professor Benston likely one day, his name has been in the paper so much.

All I want's the facts, and I want them all. And I want to hear the bad news and I want to hear the good news so I can make a regulatory decision. And some of the things I just haven't understood as to why we don't publish stuff that doesn't support us as well as stuff that does support us. And that's what I'm trying to get, is to the bottom of everything. I have a great deal of respect for all of you all. That's my point.

MR. GRAY: Do we publish things?

MR. SAHADI: All our information, all our staff studies, are available under the Freedom of Information. Act. We regularly publish information. We put these little fancy covers on them. We disseminate them to libraries all · over the country. I think we've probably been the most open Economics Department in any of the government banking agencies in terms of its research.

Now, to the extent that we didn't put every study in this reg, maybe that's a valid criticism, but we do make our studies generally public.

MR. PASSARELLI: Bob, could we interrupt right now? I think that Michael Scott, who actually has worked this analysis, will actually give us the specifics in regards to the Benston study. In that study, of the 37 that were on that list, three have failed, eight are SSCs [significant supervisory cases] and 10 of the cases have been referred to FSLIC. And you might want to go over on the specifics in those cases, Michael.

MR. SCOTT: Okay. Well, significant supervisory cases basically, it means that there is some significant problem with the institution, which supervisory people have deemed it necessary to put them into a category stating that perhaps there's going to be some restrictions on the kinds of activities that they can engage in. And based on -

MR. GRAY: And it also means that they are essentially projected to be insolvent, roughly, within a year.

MR. PASSARELLI: That's right.

MR. SCOTT: Eight of the institutions that were in the study of 37 that we've been discussing are in that category. And Board Member Henkel and Board Member White have raised the issue, well, how much can we attribute to direct investment to the position that they are in?

And I can state, in conjuction with OPER, that that is a difficult thing to do. But there are some facts that are available. And the facts from what we get from the eight SSCs is that three of them are presently insolvent. An example, one of them is under a cease and desist order. Their total assets were $175 million, and they put a direct investment of approximately $40 million into raw land. And the examiners have said, there's no doubt that's going to be a loss, a major loss. That, to me, is a factor in the institution's potential failure.

In general, all of these institutions, of course, did exceed the 10 percent of assets situation. The usual concerns--there were underwriting deficiencies. In other words, there were other factors involved besides direct investment. But, in general, they were all engaged in rapid and aggressive deposit growth, and they used that deposit growth to engage in direct investments, and, in four of the cases, there appears to be little doubt that they're experiencing these financial difficulties as a direct result of one or more of the direct investments that they made. Okay. there's as definitive a statement as can be made from a supervisory standpoint on those eight cases.

NOW,

MR. GRAY: Did these tend to be quite substantial direct investments?