United States Senate MEMORANDUM 12/13/84 Attendees for Dec 17, 1983 Meeting on Direct 1. Jim Grogan, Vice Pres and General Counsel of Lincoln Savings & Loan Association. Resides in Phoenix, Arizona. 2. Robert Kielty, General Counsel for Americaî Continental Corporation, the parent holding company in Phoenix, that purchased Lincoln S&L in Califonria 3. Charles Keating, Chairman of the Board of American Continental Corporation, Phoenix, Arizona. 4. Alan Greenspan, Economist who along with George Bentson did the economic analysis of the FHL88 proposal. They found that the data did not support the FHLBB's view and direct investment actually made institutions more profitable and made more funds available for Opinion Letter of Dr. Alan J. Greenspan to the FHLBB November 1, 1984 Mr. Steven Goldstein Financial and Quantitative Analysis Washington, D.C. 20552 Dear Mr. Goldstein: I am writing at the request of Robert J. Kielty, Esq. and on behalf of Lincoln Savings and Loan Association to state my professional opinion concerning the rule proposed by the Federal Home Loan Bank Board (the "Board") which would limit the amount of direct investments that state-chartered savings and loan associations may make (the "Proposed Rule")." Further, I am writing to express my agreement with the conclusions drawn by Professor George J. Benston on the basis of his study of associations in eleven states that permit direct investments and of savings and loan failures that occurred in the period from January 1. 1981 to June 30, 1984. I understand that Professor Benston is submitting his study to the Board together with a general summary of his conclusions. Accordingly, I will not discuss his study in detail. but I will state that it is the most comprehensive study of which I am aware that addresses directly the issues raised by the Proposed Rule and that I am in accord with the conclusions that Professor Benston draws from it. The Structural Crisis Confronting the Savings and Loan Industry The savings and loan industry in this country was created and grew to maturity under a special set of economic conditions. low inflation and relatively low and stable interest rates. These economic conditions no longer exist and are unlikely to exist for the indefinite future. The dramatic change in financial conditions during the past several years created a crisis in the savings and loan industry in the early eighties. By 1981 the average cost of funds at savings and loans had risen to an unprecedented 10.9%. Yields on long-term savings and loan mortgage portfolios, heavily weighted with older, lower yielding instruments, lagged, averaging only 9.9% that year. The Board's figures identify the nature of the resulting crisis:" While inflation and skyrocketing interest rates affected every seg. ment of the economy, they struck the savings and loan industry with particular severity. The structure of the industry's balance sheet long-term, largely fixed-rate assets matched against short-term liabilities-made associations inherently vulnerable to increases in interest rates. By the early eighties the industry was under intense strain. Many associations simply failed and either disappeared or were merged with other, stronger associations. Many others, on the verge of failure, were saved temporarily by the infusion of government funds and by the existence of federal deposit insurance. Because the crisis facing the industry resulted from a major and pre. sumably fundamental change in economic conditions it can be resolved only by equally major changes in the industry. Since the crisis is rooted, in particular, in the mismatch between the industry's longterm assets and short-term liabilities. it can be resolved only by a major restructuring of both those assets and liabilities. There is no realistic alternative. So far, the industry has been unable to induce depositors to invest in certificates of deposit of sufficiently long-term nature to lengthen significantly the average maturity of the industry's liabilities. The indusury should be encouraged to do more along this line. Notwithstanding the possibility that the average maturity of the industry's liabilities might be lengthened, it is essential that the savings and loan industry be allowed to shorten the average maturity of its assets. Adjustable rate mortgages ("ARMS"), for example, offer one method of effectively shortening the maturity of industry assets. ARMS however, are not sufficient by themselves to solve the industry's cur rent problem. ARMs are subject to a variety of "caps" and other restrictions that limit their flexibility and prevent them from being fully adjustable with respect to changing market rates. Moreover, because their interest rates may be adjusted upward, ARMS carry an increased likelihood of default and hence are riskier instruments than fixedrate mortgages. Further, given the enormous size of the industry's outstanding balance of fixed-rate and long-term mörtgages, the use of ARMS — even if they were otherwise sufficient — would not allow the industry to cure its overall asset-liability mismatch for many years. Additional corrective measures are, therefore, essential. Direct Investments are Essential for the Financial Stability and Survival of the Savings and Loan Industries In this situation. so-called "direct investments" in real estate, equity securities and service corporations offer an economically efficient — and necessary method of allowing savings and loan associations to remedy their asset-liability mismatch. This is true for several reasons. First, direct investments enable savings and loans to hold a wide range of short-term assets which allows them to match more directly the maturities on their liabilities. This would remedy the mismatch at its source. Second, direct investments offer associations an efficient method of diversifying their holdings. Portfolio diversification is critical to financial soundness, and direct investments will enable associa tions to acquire assets with characteristics that complement those of home mortgages, thus helping to bring long-term financial stability. Third, direct investments will allow associations to take advantage of. and participate in, the most promising areas of local growth and development Most associations, in fact, have special knowledge concerning local economic developments, and direct investments will enable them to use this knowledge in the most profitable. sound and effective manner for their associations, while simultaneously benefitting the economic well-being of their communities. Accordingiv direct investments constitute an investment option that is necessary to the financial health — and, in many cases, the survival - of savings and loan associations. Any artificial restriction on ra tional investment opportunities reduces the overall efficiency of the economy, and restrictions that directly impedė efficient adjustments mental to the associations and to the nation as a whole. Although some direct investments are certainly more risky than some traditional savings and loan investments, whatever risks direct investments may entail are far less dangerous and acute than the risks that currently confront the industry. The risks currently imposed on the industry by fundamental changes in economic conditions and by assetliability mismatch are severe and immediate, and the use of direct investments to avoid or minimize them would lessen the risks facing both the savings and loan industry and the economy as a whole. Under present and foreseeable future economic conditions, broad utilization of direct investments by savings and loans should lower the industry's overall level of risk and place it on a safer and sounder footing. The Board's Proposed Rule Restricting Direct Investments Is It is my opinion that the Proposed Rule imposes limitations that are unsound in principle and that will prove to be harmful in practice. The Proposed Rule is based on assumptions that are unsupported by the available evidence and simply contrary to fact. First, the Board assumes that the Proposed Rule will protect the savings and loan industry. This is not true. To the contrary, it will most likely cause serious injury. In my opinion, for every association that may be prevented from taking undue risk by the Proposed Rule. many will be positively harmed. The reason for this is that the indusay as a whole requires the broad ability to make direct investments in order to restore and ensure its economic stability and prosperin The industry simply cannot overcome the structural problems that threaten if it associations are restricted generally in the ¿ypes of investments they are permitted to make. Second, the Proposed Rule assumes that direct investments are riskier than traditional savings and loan investments. Some are, and some are not. All investments carry risks, and home mortgages are no exception. A traditional home mortgage, for example, must be based on fifteen to twenty-five or even thirty year projections about 'For example, even in apparentiv secure and safe home mortgave carries an interest rate that is higher chan the rate paid on AAA rateu corporate bonds. The Juference in the mŋ interest rates is a measure |