And so unlike a private insurance company, we can't simply cancel or non-renew the policy. Another thing which a private insurance company could do, where the risk is excessive, or is perceived as excessive, is to raise the premium, and of course the FSLIC, in essence, did that awhile back by imposing the special assessment. But that's not really the same thing. That, as was said, we have, as you have pointed out again and again, what, in essence, is a group insurance scheme with the FSLIČ where all of the insured members pay the same premium regardless of the risk they impose on the system, and that premium, even with the special assessment included, is nowhere near enough income to cope with the burdens which the FSLIC has and is incurring; if our analysis is correct in large measure, certainly not in sole measure based on the additional risks that result from direct investment.

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Mr. GRAY: Then I'd like to go beyond that. We are not talking about, here, money coming in from thrifts alone in premiums. We are talking about money that is insured by the United States, itself, and which the taxpayers have to stand behind, if there are not other means to deal with this problem, and, for that matter, recapitalize the fund. So, we're talking about institutions taking high risks, not on their own money figures show they are taking high risks on somebody else's money. the somebody else's money is involved in a loss, the ultimate somebody else's money is the taxpayers of this country, and the citizens of this country. And that's a little bit different from a private insurance company, since we're making comparisons.

as the
And if

MR. HENKEL: Mr. Chairman, let me tell you, we're all in agreement on protecting FSLIC. I mean, all of us are dedicated to that.

MR. GRAY: Well, you know, the way you are dedicated to protecting FSLIC is to try to be a good underwriter. I mean, you know, you can't just say that "I'm interested in protecting FSLIC." I mean that--it takes actions, not just saying "I'm for protecting the FSLIC," and that's what we're here today to talk about. What are the actions we're going to take?

MR. HENKEL: I agree with that a hundred percent, but I'd like to pose this question. This direct investment reg was first passed January 31st, '85. The principal study we're talking about now, which tends to indicate increased thrift costs and failures was June or October of '86. We get contrary views now, and there's a big debate about whether direct investments do or do not cause failures.

I don't think we still know, and I pose the question: why didn't we start finding out January the 31st of '85, what really caused these things? Was it examination failure? Did we not close them quick enough? Did we not rout out the "bad guys?" Are direct investments indeed something we ought to stop completely?

MR. GRAY: Well, we're not talking about the reverse.

MR. PASSARELLI: One point you gotta keep in mind about the examination process, it's after the fact. I mean, these institutions already made their investments. They've incurred a risk, and the examination comes on after the fact. And then what has happened, these things mature, and when they mature, it's when the problem occurs.

MR. HENKEL: Oh, I understand.

MR. GRAY: Right.

MR. PASSARELLI: I mean that's the thing you gotta keep in mind. Everybody thinks about the examination/supervisory process as being the cure-all. It's not the cure-all because those people are operating. They operate independently. I mean, they perform, and based on the regulation, you realize they've got 10 percent of their investment in direct investments. That's a very large amount that they can invest in, and an institution can get those kind of investments, and when the examiner and the supervisory people get in there, those investments could actually not, uh, matured at the time to show the weakness that exists in those type investments. And I think you gotta keep that in mind.

MR. HENKEL: Oh, I understand what you're saying, but all I want to know is, what caused the problem? Was it crooks? Was it--you know--was it really direct investments? What was it?

MR. PASSARELLI: Well, basically, what you'll find out on all these cases is that they weren't properly underwriting, they didn't have the proper feasibility. I mean, lots of those things that you're going to recognize in this. That's what makes these high-risk type of activity. They didn't do the necessary underwriting that would actually provide the protection to the institution and to the FSLIC. In other words, these are after the fact, and the people who made these loans didn't prepare the necessary underwriting, didn't maintain proper records, they didn't do the proper inspection. They didn't do everything that's prudent. And I think that's the problem. And there's where the weakness comes about. Lots of these institutions, they think they can handle--like, for example, you talked about Sunrise. That institution came into existence--within three or four years, they became a million, four. In other words, that kind of activity

MR. GRAY: A billion, a billion four.

MR. PASSARELLI: I mean a billion, four. I mean, the whole point is this: with that kind of investment activity, you go in there, it's afterthe-fact. They've made their investments.

MR. GRAY: Well, I think there's another point here, too. If we are going to get the definitive study on everything, we'll be out of business Tong before we reach that point, and it'll be all an academic matter. Now let me say one other thing. It's interesting that we're talking about direct investments here because we're only talking about state-chartered institutions. We're not talking about federals.

Interesting that in 1982, when the Congress passed the Garn-St Germain Act, it did not increase the ability of federally-chartered institutions to make direct investments in excess of 3 percent of assets. And I will have to ask the staff, but it seems to me, that in terms of the kinds of losses that we have suffered in this fund--many of the biggest losses have not come from federally-chartered institutions, but rather from state-chartered institutions.

Is that your general belief, staff, around the table?

MR. BLACK: It's clearly our experience in the losses we deal with in litigation, there's no question about it. Passarelli, Mr. Passarelli

MR. GRAY: Is that generally correct that these are statechartered institutions, the ones that have the authority that go well beyond anything that Congress provided in its law for federally-chartered institutions?

MR. BLACK: Right. I'd also say that this is the most studied regulation in terms of econometric analysis of any regulation, in the Board's history, by a very considerable margin; a very substantial. amount of OPER's resources have been devoted to try to do studies and they didn't just stop the first time around. They did follow-up studies. The studies continued to go forward so if you want to talk about after-the-fact how much was lost on each direct investment--you have to remember a place like Sunrise, you're talking about at least hundreds of individual assets, which, even today, may be two years from being sold and may not even be appraised at this point. You will be gone, if you're wrong, before you get those numbers.

MR. PASSARELLI: I think another point you gotta be bringing out here is, the good operators, they can continue to make these investments. That's the thing you gotta keep in mind. We've got a system in place that provides for the good operators to continue to make these kinds of loans, and we're not restricting those people. Those people can manage and present their kind of business plan, how they want to make additional investments in excess of 10 percent. We review it, and we give approval to it. It's those people who are not good operators; who do not underwrite the loan properly; who do not maintain proper recordkeeping. Those are the kind of people that we're actually controlling. The good operators continue to make these kind of investments and we bless them.

MR. GRAY: Well, let me take that one step further. Bob, I believe that you have done a very recent study that talks about institutions that have tangible net worth. That's where basically you back out from GAAP, generally accepted accounting principles you back out goodwill.

Do we know how much goodwill we have in this industry, in total?

MR. SAHADI: Yes. Let me give you some numbers here.

MR. GRAY: Let me characterize in my view goodwill as being in very, very, very substantial part, nothing more than hot air.

MR. SAHADI: We have $50 billion in regulatory net worth in this industry. $25 billion of that is goodwill. So, exactly half.

MR. GRAY: So, exactly half of the net worth that we have in this industry is goodwill. Hot air. All right.

GAAP.

MR. NEUBERGER: Which is included in GAAP. Goodwill is included in

MR. GRAY: Oh, I understand it's included in GAAP, but I'm just saying it doesn't protect the FSLIC--hot air does not protect the FSLIC.

MR. NEUBERGER: That's correct.

MR. GRAY:

It's not a cushion. Now, let me go step a step further. You did a study of the number of institutions we have in the industry with tangible net worth without goodwill, GAAP without goodwill, and I believe you found it was something like 880 institutions.

MR. SAHADI: Well, I divided them into three categories. I looked at institutions in California, Texas, and all the other institutions. There were 2700 institutions nationwide other than in those two states. Of those 2700, 881 have tangible net worth greater than 6 percent.

MR. GRAY:

All right. Now, I'm getting at something because I'm taking off and going a step further from where you were. We're talking about good operators being able to exceed the threshold, and 60 percent have been able to that.

Now, let's take our net worth standard, which we had in our net worth regulation, which was adopted several months ago; and let's assume, for purposes of this discussion, that instead of regulatory net worth at 6 percent, we're going to take tangible net worth at 6 percent. People who have their own money on the line, tangible net worth, 6 percent; how many institutions in California with their own money on the line, very strong in terms of tangible net worth, have chosen to exceed 10 percent of assets in direct investments?

MR. SAHADI:

73 institutions in California who have tangible net worth greater than 6 percent. Of those 73, eight institutions with tangible net worth.

MR. GRAY:

in Texas?

Only eight institutions. Can you give us what figure is

MR. SAHADI:

In Texas, there were 54 institutions in the universe and

only three have been involved in direct investments

MR. GRAY:

You're saying 54 that have tangible net worth in excess of 6 percent or more, and only three of those that have tangible net worth of that magnitude are into direct investments in excess of 10 percent.

So, you have in California and Texas a total of 11 institutions with their own money on the line, am I right?

MR. SAHADI: Right.

MR. GRAY: Why do you think that only 11 institutions out of that universe of 87 and 54, I think, have chosen to go into these riskier kinds of investments, only 11, why is that? Why do you think? Obviously I'm asking a judgment question.

MR. SAHADI: Well, I think, basically we have a term that comes from Wall Street which is called "capital at risk," and people, when they have their own capital at risk, they tend to be very conservative in the investments they do get into, and I think that, as was pointed out here, is that here are institutions that probably took a good deal of time to build up the 6 percent tangible net worth and they're going to-

MR. GRAY: In other words, they don't want to lose it.

MR. SAHADI: Not to say that these institutions aren't involved in direct investments.

MR. GRAY: No, no, I'm saying in excess of 10 percent, there are only very few.

MR. SAHADI: In excess of 10 percent. But that they would look up this possibly as something they would like to do, but look upon it in a photo portfolio context and in something in relation to their ability of capital to withstand a loss from it.

So, they've got 6 percent hard capital and so that in effect-

MR. GRAY: Doesn't that say something to you?

MR. SAHADI: Those types of people would say, I'm going to put this much capital at risk, given a project. I may put 25 percent of my capital at risk, which, 25 percent may be 1.5 percent of their capital or maybe I'll put 50 percent of my capital at risk, which, is 3 percent. And what we're saying is, in effect, you could put 200 percent of your capital at risk, only it doesn't even have to be tangible, it can be regulatory which, as we said, is 50 percent goodwill.