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. Now, there's as definitive a statement as can be made from a supervisory standpoint on those eight cases.

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

MR. SCOTT: Looking, in general, direct investments, I'm looking at five institutions. Let me just give you some quick numbers: Total assets, one institution was 280 million. Direct investments was 62 million, 22 percent of assets in that particular institution; 220 million, 15 million involving direct investments. In other words, a significant percentage of the portfolio of these institutions included direct investments.

Did they contribute to the profitability of the institution? That's a question that we can't get at from this data alone. All I can tell you is that in three or four cases, absolutely, out of the eight, there was a high level of direct investment, and that caused an excessive loss to the institution.

MR. GRAY: All right.

MR. HENKEL: Let me go back to one other thing. Bob, you were mentioning we published -- I'm just curious about this now, as a lawyer. This is the paper we're talking about -- bound in Board paper, obviously distributed, says things that indicated causes -- excessive cost to FSLIC. And if I was a lawyer, I'd love to have this, to argue that side of the

case.

Here's a paper by the same folks, with one more -- Wang -- that has some language in there which I could argue on the other side, and it doesn't have any brown back on it. I don't see any indication that it's been distributed. Are we giving equal publicity to both views?

MR. SAHADI: If anybody wants a copy of that other paper, they're free to have it, but that paper is still a working document and it hasn't been we have a procedure, we have an editor on our staff, that once papers come in and they want to get into that particular series with the fancy cover on it, we have a staff review process where we assign it to three people on the staff, senior-type people that look at it, and get into a collegial type process, just as, you know, maybe people do on faculties, and, you know, get into some kind of professional "give and take." And then once everybody's convinced that this paper is you know pretty important and significant, and doesn't have any flaws in it, then we put a fancy cover on it and send it out.

That paper you're showing is still in process and hasn't gone through that review process yet.

MR. BISENIUS: Although, just for clarification, the paper was cited in the Capital Regulations that were adopted in August, and was distributed --you know-- to the public reading rooms for review at that time.

MR. HENKEL: We cite it and yet we haven't completed it? You know, that doesn't made any sense to me.

MR. SAHADI: No, as I mentioned, we have a process where we do -- we have internal working papers that we make available to the public - this is the document you're fingering through and then we also have a technical research series that is intended to be something of benefit to college libraries and institutions. And so we, you know, go through a different type of review process, and put a cover on it, and send it out to libraries. There are papers of they're just sort of a different audience, so to speak.

MR. HENKEL: But with a language in there like: "earlier findings indicated that direct investments do not adversely affect the likelihood that an institution will be closed." Isn't that something we ought to at least let everybody look at? I mean, it's another academic view, and it's one by the same three folks.

MR. BLACK: Well, let me person under attack to respond as is not submitted for publication. cover through the same procedure. through the public reading room.

I mean, it's difficult I think for the
forcefully as you probably should. This
When and if it is, it gets the same brown
It has been made publicly available

It was sent by its authors to George Benston immediately and other opponents of the rule. It is preposterious and, indeed, insulting, to suggest that this study is somehow being suppressed by OPER. It has been broadly disseminated and the opponents of the regulation have had access to it and know all about it, and Board Members have been fully briefed on the existence of this study, and on the limitations of the study.

MR. HENKEL: I wasn't using the word "suppressed," I was using the words, "equal publicity.'

"

MR. BLACK: I stand by --- we both stand by our statements.

MR. GRAY: In other words, you want these well, that's mind. I won't get into that. All right. Let's continue.

... never

MR. SAHADI: Okay. One of the comments that's been brought about, that we were measuring regional economic distress, as opposed to really accurately measuring direct investment as an activity for investment by failing institutions.

In order to isolate this regional characteristic, we looked at a number of institutions in California that had been involved in direct investments. California does have liberal investment laws allowing thrift institutions, state-chartered thrift institutions there, to go up to -- I guess it's 100 percent of -

MR. GRAY: To place 100 percent of their assets in service corporations, which is a euphemism for direct investment.

MR. SAHADI: Uh-hum. In order to be very conservative, we said instead of looking at the 10 percent threshold that our proposed reg cites, we would look at 5 percent as a cutoff point. And we found that there were 33 institutions that had greater than 5 percent of assets at the end of '83 in California. Twenty of these institutions are now problem cases. The cost of FSLIC to resolve these twenty institutions is over $3 billion.

The average ratio of regulatory capital of these 33 institutions was 3 percent in December '83, which was slightly above the required capital at that time. In September '86, that ratio had decreased to a negative .3 percent.

MR. GRAY: You're saying that these institutions, which in December of '83, had in excess of 3 percent regulatory net worth, have slipped to a negative average insolvency of ---.

MR. SAHADI: Point three percent.

MR. GRAY: Point three percent?

MR. SAHADI: That's right.

MR. GRAY: And the negative return on assets in September of '86 for these institutions was in my notes here -- 3.345 percent, as opposed to their return on assets in December of '83, which was 0.66 percent?

MR. SAHADI: Correct. We characterized, or we compared them, I should say, to 148 institutions that had direct investment levels below 5 percent. Of these 148 institutions, as of December '83, they had a capital ratio of 4.7 percent. In September of '86 that had grown to 5.4 percent.

More interestingly, they had a return on assets of 48 basis points. That had almost doubled to 86 basis points as of September of this year.

So I think what we're seeing is that, by and large, in California, those institutions that even had a 5 percent or greater level of direct investment have lost capital, and are significantly losing income at this time; whereas, institutions that were below the 5 percent thresholds -- not to say that they didn't use direct investment in a prudent manner -- have doubled their profitability during that time period and are quite healthy at this point, and are well in excess of our capital standard with a 5.4 percent average capital level.

MR. GRAY: Let me go through my notes here, and talk about the 13 California institutions that are cited in this study, which had direct investments on their books in excess of 10 percent of assets in December of '83.

Eleven of those now are in they remain. In December of '83, they reported regulatory net worth of 2.7 percent, a negative return on assets even at that time, of 1.72 percent. But by September of this year, just several months ago, those same eleven institutions which remained were reporting average negative net worth of 9.692 percent and an average negative return on assets of 12.69 percent.

And I would point out from my information here, that three of them are -- three of the eleven are projected to be insolvent within a year. That is, they're in our significant supervisory caseload. Five are FSLIC insolvencies and two have failed.

And if my figures are correct I believe you can correct me if I'm not they are projected to result in losses to the FSLIC of an estimated $1.9 billion, which is not too far short, just for thirteen institutions, of the entire primary reserve that we have in the FSLIC fund for thirteen institutions.

MR. SAHADI: By way of comparison, in those that had below 5 percent direct investments, of those 148 institutions, eighteen have failed over this time period. So that is eighteen over 148, or, you know, something like 12 or 15 percent have failed; as opposed to, of the thirty-three, twenty have failed. So we're talking about a 60 percent failure rate versus a 15 percent failure rate. A four-to-one failure rate.

MR. GRAY: Now, these 24 California institutions that had direct investments in December of '83 in excess of 5 percent of assets and are now either insolvent, projected to be insolvent soon, or have been closed, those institutions, you say, are projected to cost the fund $3.15 billion. And that is $900 million more than we have in the reserves of our fund for twenty institutions in California alone.

Let me ask you: I'm not an economist like you, Dr. White, and I'm not a lawyer, either. But, it's interesting to me, I must say, that looking at these studies, both of the thirty-seven, and then the California experience --that these same institutions which were healthy in December of 1983, have come to such a demise, in large part --- such an incredible demise.

I find it difficult to see this as being merely a thing of chance. any of you have any comments on that? I want to talk to you as a layman about what this somehow means. I mean, it is very strange that this would happen with these institutions. Have any comments? Bill?

Do

MR. BLACK: Well, I mean, clearly we don't think that it's a matter of chance. Supervisory experience suggests that it's not a matter of chance. It suggests that there are a group of folks who are plungers, who are not at all risk-averse, who are particularly susceptible to very severe losses. The basic economic theory suggests that these assets are riskier, in terms of a more precise definition of chance. That's what statistical confidence tests are designed to say. Is it a chance that we're looking at simply random variation in the information? And that would be, apropos Board Member Henkel's point, I think the question that he would have.