"You know, what really happened here is that the government stole $800 million from us."

          --- Roger S. Hillas, chairman of  Meritor and former chairman of PNC Bankcorp.

     When interest rates skyrocketed in the early 1980s, hundreds of savings and loans were faced with a huge dilemma.  For over 50 years, they had made their living by “borrowing short” (taking in short-term, due-on-demand deposits from consumers) and “lending long” (loaning the same money out for 30-year home mortgages).  They would, for example, pay four percent interest on a passbook account and then re-lend the depositor's money to another customer for a home mortgage at, say, six percent, pocketing the two-point "spread".   However, when Congress deregulated interest rates in the late 1970's, the price thrifts had to pay to their depositors skyrocketed while the interest coming in on their long-term portfolios of fixed-rate home mortgages pretty much stayed the same.  Huge losses resulted and hundreds of thrifts were on the verge of collapse.  As a result,  the two federal agencies which insured their deposits, the Federal Savings and Loan Insurance Corporation (FSLIC) and its sister agency, the Federal Deposit Insurance Corporation (FDIC), were facing a $20 billion payout.  Since they didn't have anywhere near that kind of money on hand and were loath to face the wrath of Congress by asking for a special appropriation, they instead sought to merge the sick thrifts into their more financially solid brethren.  Since the two federal agencies were short on the cash needed to make the deals work, they offered the healthy thrifts, as compensation, the opportunity to offset the liabilities they were being asked to assume with a counterbalancing asset called "supervisory goodwill" -- without which, as the U.S. Supreme Court later ruled, the transactions would have made no economic sense whatsoever.

     The deal the government offered went like this:

In exchange for their willingness to assume the $20 billion in debt (some estimates put the number at $30 billion or higher), the acquiring thrifts were given an equivalent amount of an intangible, "paper" asset called “supervisory goodwill”.  (It is called "supervisory" goodwill because it originated out of government supervised mergers).  In most cases, the thrifts were receptive to the government's offer, but in others -- such as Glendale Federal Savings and Loan Association of California ("GlenFed") -- they had absolutely no interest in taking over a failing institution unless the government ponied up cold, hard cash to fill the "hole" which would instantly show up on GlenFed's balance sheet once the sick thrift's net liabilities were added to its own.  In such cases, the regulators used other means to convince the thrifts to "assist" their government.  In GlenFed's case, it found that its pending application to acquire a smaller (and financially healthy) competitor in California was going nowhere until it agreed to also acquire the failing Broward County Savings of Florida -- some 3,000 miles from its base of operations and in a state in which it had never done business.

Without obtaining an offsetting asset, of course, the thrifts would have created an instant $20 billion “hole” on their collective balance sheets were they to have acquired the failing thrifts outright -- and hence, none of them were interested in doing that. Thus the government's offer that they would be allowed to include "supervisory goodwill" on the asset side of their balance sheets in an amount equal to the liabilities they were being asked to assume literally meant the difference between solvency or insolvency for many of the thrifts.  And although the government specifically agreed to allow the thrifts to count the goodwill as an asset going forward for capital computation purposes -- granting them permission to write it off over a period of anywhere from 15 to 40 years -- it cannot be denied that the goodwill was, as the government has repeated ad nauseam, a non-tangible, non-fungible “paper” asset.  Nonetheless, the thrifts were willing to accept it in payment from the government because during the lengthy period of years during which the goodwill was to be written off, the thrifts planned to use the $20 billion in deposits to generate more loans, figuring that they could make enough money on the new loans to eventually pay off not only the original $20 billion in debt which they had assumed, but earn a profit as well.  The key, of course, was to keep the thrifts' balance sheets in proper order and that's where the supervisory goodwill came in; the $20 billion of goodwill on the asset side would balance the $20 billion of additional deposits on the liability side, thus keeping the thrifts solvent on a “book” basis. (1)

     There matters stood until 1989.  By then, many other problems caused by Congress's deregulation of the thrift industry in the early 80's were coming home to roost.  For instance, Congress told the thrifts -- which for 50 years had only been allowed to invest in residential mortgages -- that they could and should expand into new areas such as commercial real estate and high-yield bonds.  Many thrifts followed that advice and many suffered very poor results, often, without a doubt, because of their own faulty judgment.  In addition, the industry attracted a fair amount of fraudulent operators who were attracted to the idea of obtaining cheap funding in the form of federally insured deposits.  Altogether, Congress' "fix" of the 1980-82 S&L crisis was, in hindsight, a prescription for disaster and as is so often the case, Congress then decided to fix the problem again (but only after the horse was out of the barn), slamming on the brakes with a new piece of legislation called the Financial Institutions Reform, Recovery and Enforcement Act of 1989 ("FIRREA").

     For starters, FIRREA required the thrifts to swiftly curtail their exposure to real estate lending, resulting in the wholesale dumping of millions of square feet of office space, shopping centers, golf courses and other commercial property onto an unprepared (and overbuilt) market.  Next, the high-yield bond market collapsed under the weight of relentless selling by thrifts which had also been ordered to substantially reduce (or liquidate outright) their high-yield bond portfolios.  (Seeing the handwriting on the wall in terms of what Congress had done to the banks and thrifts, insurance companies, which had also been sizable buyers of high-yield bonds, decided to head for the exits and became sellers instead, pouring even more gasoline on the fire and further depressing prices).  As if those two developments weren't bad enough, many American corporations suddenly found themselves without needed financing as FIRREA also severely restricted "HLT" lending (i.e., "highly-leveraged transactions").  As should have come as no surprise, the resulting Credit Crunch brought on the nation's most severe recession since the Great Depression of the 1930s, costing President  George Bush, whose administration had crafted and sponsored FIRREA (although a Democratic Congress is equally to blame), his reelection bid three years later.

As for supervisory goodwill, it, too, became a victim of FIRREA.  Although the use of supervisory goodwill had been a valuable tool which had helped the government dodge an earlier $20 billion bullet -- and even though its use had been designed and authorized at the highest levels of government -- there were many career employees of  the FSLIC and FDIC who had never agreed with the idea of counting any intangible asset towards minimum capital ratios and they lobbied their many friends in Congress accordingly.  Congressmen and Senators, hearing that on top of everything else, there was $20 billion or more worth of “phony” assets on the books of the nation's thrift industry, thundered righteously that supervisory goodwill was nothing more than smoke-and-mirrors, an “accounting gimmick”, etc.  They were right, of course -- but because they had fallen victim to a massive "disconnect", they were only half right.  What one Congressman at the time described as "the rush-to-judgment called FIRREA" conveniently overlooked was that the $20 billion liability which offset the goodwill was real; very, very real.  In eliminating supervisory goodwill, Congress did not, of course, relieve the banks of their responsibility to make good on the $20 billion in deposits which the thrifts had assumed on the government's behalf seven years earlier.  As just one example, the oldest thrift institution in the nation, the Philadelphia Savings Fund Society, ended up paying the depositors of the failed Western Savings Bank of Philadelphia over $800 million (the equivalent of roughly $15 for every share of its stock) plus interest before it was itself seized and put out of business by the very regulators who had enticed it into accepting supervisory goodwill (instead of cash) in the first place.

As a result of the passage of FIRREA, hundreds of thrifts instantly found themselves below minimum capital ratios, as the goodwill could no longer be included as an asset.  (Capital ratios are the product of dividing total equity and reserves by total assets).  Dozens were seized by the regulators and shuttered; others, in the midst of a terrible recession and "credit crunch", scrambled to find replacement capital, usually at the cost of virtually wiping out the interests of their existing shareholders.  Outraged by what they considered a $20 billion dollar double-cross, the thrifts went to court, with over 120 lawsuits being filed against the government for breach of contract.  In 1992, the chief judge of the U.S. Court of Federal Claims ruled against the government in the first three suits, collectively titled the Winstar cases (Winstar; Glendale Federal Savings, and Statesman Savings were the plaintiffs), whereupon the government appealed.  After first being reversed by a three-judge panel of the U.S. Court of Appeals for the Federal Circuit, the chief judge's ruling was upheld in an unusual en banc hearing in front of all 11 judges of the court of appeals.  Rejecting, in a 9-2 verdict, the government's numerous and creative arguments as to why the thrifts' had never had valid contracts to begin with, the Court of Appeals found that there was "nothing unusual" or unique about the contracts except for the "huge amount of money" at stake.  When the government appealed yet again, the U.S. Supreme Court, in the summer of 1996, also sided with the thrifts in a 7-2 vote.

Despite having been soundly defeated by the courts, the government ferociously fights on.  Having been found guilty of breach of contract in the first three of the 120 cases, it now takes the position that despite the shifting of over $20 billion in liabilities from FSLIC and FDIC to the thrifts, no harm was done to them and they are thus entitled to zero damages.  In the cases of those thrifts which survived the elimination of their supervisory goodwill (such as GlenFed), the government has argued that the thrifts were actually helped by the breach because it supposedly prevented them from making more "bad" loans.  However, where such an argument is simply not plausible (because, after all, the thrifts had been seized by the regulators -- i.e., Meritor (MTOR); Security Savings (SSLN); Ben Franklin Savings (BENJ) and thus were never in a position to make more loans, good or bad), the government arrives at its pre-determined result of zero damages by arguing that it doesn't matter because they all would have gone out of business anyway. (2)

As for the other 120-odd cases, the government now argues that the Supreme Court's Winstar ruling is not binding precedent and that each must be tried on an individual case-by-case basis -- after which each must presumably go through a second trial (as the Winstar plaintiffs have been forced to do) to determine the amount of damages, if any, to which they are entitled.

 (1)  At a recent hearing before the U.S. Court of Appeals for the Federal Circuit in the GlenFed and CalFed cases, Judge Richard Linn inquired as to whether, back in 1982, the government might not have had another alternative to paying off the depositors of failing thrifts absent the agreement of the healthy thrifts to assume the liabilities instead.  Lawyers for the thrifts argued that to the contrary, encouraging the healthy thrifts to take over their sick brethren in exchange for  "supervisory goodwill" was the last tool remaining in the regulators' arsenal and that without it, Congress would have been forced to appropriate billions because, as the then-chairman of the FDIC, William M. Isaac, was to later testify, "we had a $100 billion problem and only $11 billion to fix it with".

That the thrifts' position is the correct one has been proven by history and, accordingly, the answer to Judge Linn's question can be found by studying what happened the next time the government faced a crisis in the thrift industry.  As was the case in 1982, the government by 1989 was faced with an unprecedented number of failing thrifts, and as was also the case seven years earlier, FSLIC and FDIC were basically broke.  But unlike in 1982, however, the use of "supervisory goodwill" had been specifically forbidden by Congress.  Without its availability, the regulators had no choice but to petition Congress  for hundreds of billions to set up a new government agency, the Resolution Trust Corporation ("RTC")  for the specific purpose of taking over and liquidating hundreds of failing thrifts.  Estimates of the ultimate cost to the taxpayer range from $175 to $250 billion.

 (2)  Interestingly enough, each seized institution had received a particularly harsh Report of Examination from their regulators shortly before being closed down.  Later, Rosemary Stewart, former Director of Enforcement of the Office of Thrift Supervision, would admit in an interview that "beginning in 1988 there was a desire to write that final exam report to justify the (soon-to-be) Receivership.  (We were) always concerned about (court) challenges . . . a lot of which were filed.  (So) the last report may not be a true reflection of regulators' views".  (See Bank Bailout Litigation News, Vol. 7, No. 19, July 15, 1996).  Indeed, Meritor's final Report of Examination, delivered to the bank just minutes before it was seized, is markedly different from the conclusions drawn by Price Waterhouse when it examined the bank's condition after the seizure.