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College of CharlestonFinancial Institutions Reform, Recovery And Enforcement Act of 1989Eric SpectorFINC 313Professor EvansJanuary 30th, 2018Financial Institutions Reform, Recovery, and Enforcement Act of 1989IntroductionIn 1989, the Financial Institutions Reform, Recovery And Enforcement Act  (FIRREA) was signed by President Bush to try to resolve the Saving and Loans Crisis (S&L).  The S&L crisis occurred between 1980 and 1994. During this period more than 1,600 banks failed and the overall cost of the crisis has been estimated to up to $160 billion including $132.1 by federal taxpayers. The crisis started in the early 1980s due to historically high-interest rates that were put in place by Fed chairman Paul Volcker. Volcker’s policy of raising the federal funds rate, in response to inflationary problems kept interest rates high, which led to a negative spread at the peak of the S crisis. Banks became unprofitable banks due to maturity mismatching due to the asset/liability mismatch. Net income among S’s in 1980 was 781 Million and in 1981, 1982 each fell it fell to NEGATIVE $4.6 billion and $4.1 billion respectively.  FIRREA was needed and established to close hundreds of insolvent thrifts and provided funds to help out depositors. FIRREA transferred it’s regulatory supervision and dramatically changed the savings and loan industry. The overall goal of FIRREA was to require more strict capital requirements that would incentivize Saving and Loans (S) owners and managers to reduce the riskiness of their asset portfolios. In specific,  FIRREA imposed new limitations on the amount of certain high credit risk assets that an S may hold.  Before FIRREA was enacted, Savings and Loans faced different regulations and were regulated by the Federal Home Loan Bank Board (FHLBB) and were insured by the Federal Savings and Loan Insurance Corporation (FSLIC).  When FIRREA was signed, both the FHLBB and the FSLIC were abolished. As FIRREA brought spent 50 Billion dollars to shut down S banks that were insolvent and were continuing to face losses.  New institutions were now in charge of the S industry such as the OTS, the FHFB, and the FDIC.  These institutions were responsible for ridding the system of high-risk activity and the acts forbearance that the FHLBB and FSLIC had previously utilized that had caused the crisis.  Today, federal regulation nows encourages loan origination.http://fhamortgagemag.com/wp-content/uploads/2012/07/Mortgage-Rates.gifHistory of Legislation in S Industry Pre Firrea Legislation of the S industry was developed separately from commercial banks and mutual savings banks. The legislation of S was driven by the social goal of promoting home ownership. The first legislation of the S industry was from the Federal Home Loan Bank Act of 1932. The Federal Home Loan Bank Act provided a source of liquidity and low financing by establishing the Federal Home Loan Bank System. This system was under the supervision of the Federal Home Loan Bank Board (FHLBB). The FHLBB was responsible for supervising 12 regional Home Loan Banks. Although these Home Loan Banks were federally sponsored they were owned by thrift-institution members through stock holdings. The Home Owners Loan Act of 1933 allowed for the FHLBB to both charter and regulate these savings and loan associations. The FHLBB promoted the expansion of the S industry as there interest was to promote home ownership and wanted to ensure that home mortgage loans were readily available. In 1934, the National Housing Act created the Federal Savings and Loan Insurance Corporation (FSLIC) that provided deposit insurance for S’s. However, unlike commercial and mutual savings banks that were independently insured by the FDIC, the S&L industry was insured by the FSLIC which was under the authority of the FHLBB. As noted above, now the FHLBB was able to both federally charter S&Ls and insure them, while the FDIC kept these functions separate. the two functions were housed within the same agency. Unsurprisingly, the FHLBB supervision of the S&L industry were seen as weaker than other federal banking agencies. While issues were limited up until the early 1980’s at the beginning of the S crisis some important acts were passed that fundamentally changed the industry.  First, the government passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA). DIDMCA phased out Regulation Q a part of the Glass Steagall Act of 1933 that prohibits banks from paying interest on deposits.  This took away the interest rate ceiling and expanded the services that S could invest in. For example, S’s could now invest in consumer loans, commercial paper and corporate debt securities. Another policy of deregulation was the Garn-St Germain Depository Institutions Act of 1982.  This act further supported DIDMCA and allowed for an increase in the capabilities of the investment of consumer loans, allowed for loans to secured in nonresidential real estate, loans in personal property for both rent and sale, educational loans, etc.  By deregulating the S&L’s Congress strived to minimize the high-interest rate risk. However, these laws removed loan to value ratios also.  This now permitted S’s to make highly risky loans. Why Was FIRREA Needed? As Volcker raised the federal funds rate, in response to inflationary problems interest rates remained high, which led to the negative spread seen during the peak of the S&L crisis. As these banks became unprofitable banks due to this maturity mismatching. As inflation further increased the market interest rate that S&L’s had to pay for short-term liabilities. This policy that no longer tried to contain the market interest rate and instead worried more about controlling the growth rate of the money supply.  Volcker’s policy led to a decrease in money supply which led to interest rates skyrocketing. This demand for money was stronger than the supply which led to the price of money increasing. This led to an interest rate mismatch. These high rates for funds led to increasingly lower returns on their old on fixed-rate loans.  As a result, by 1982 the average cost of funds for S&L was over 11%, and the average return on mortgages was just under 11. This mismatch led to a massive rise in the number of S&L failures. In 1980 there were just 35 S&L failures, while in 1982 there were 252. Just in 1982, 7% of all FSLIC insured institutions had failed. By the end of 1983, 35 percent of S&Ls were seen as unprofitable and 9 percent were seen as practically bankrupt. Instead of shutting down these S&Ls, the FSLIC used many accounting tricks and other tactics to try and keep some of the most insolvent and illiquid S&L’s afloat. This led to these S taking on tremendous credit risk. With many insolvent S’s still running operations, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St Germain Depository Institutions Act of 1982 which deregulated these institutions and allowed them to participate in high risk investments.  Now these insolvent S&Ls now had increased investment powers to try and became solvent again. The deregulation that occured in DIDMCA and the Garn-St Germain depository led to declining interest rates. The average return on mortgages once again exceeded the savings and loan associations’ average cost of funds. As inflation increased the market interest rate that S’s had to pay for short-term liabilities. This led to massive growth in the industry and in fact from 1982 to 1985 S&L assets grew by 56 percent which was more than double the growth rate of savings banks and commercial banks of around 24 percent. This growth was due to the large number of depositors and also due to the increased investment opportunities from this deregulation. Many aggressive entrepreneurs saw the deregulation as an opportunity to make big profits. While many insolvent institutions should have been closed down this deregulation allowed some S&Ls to invest in high risk investment opportunities.  As these S&L’s went under the FSLIC continued to try and provide funds. These S that were not held accountable for making risky loans continued to make bad loans which led to continued losses. Eventually the FSLIC ran out of Funds and was recapitalized by taxpayer money in 1986 and 1987. However, in 1987 the FSLIC officially declared that is was insolvent which led to FIRREA.  FIRREA cost 50 billion and closed down failed banks to stop continued losses.        http://econlib.org/library/Enc/art/lfHendersonCEE2_figure_040.jpgWhat Was FIRREA? On top of shutting down failed banks and repaying depositors, FIRREA shut down many of the institutions responsible for the S crisis and set up new regulations to prevent another crisis.  Taking the charge, FIRREA created the Resolution Trust Corporation (RTC) which was responsible for closing or saving 747 thrifts with total assets of $394 billion.  Also, FIRREA shut down the FHLBB which was tasked with overseeing and regulating the Federal Home Loan Banks. The overseeing of these banks were now under the responsibility of the Federal Housing Finance Board (FHFB). Also, FIRREA created the Office of Thrift Supervision (OTS) which was now responsible for the regulatory supervision of the Federal Home Loan Banks. Also, the FSLIC was abolished and all assets and liabilities were now controlled by the FSLIC Resolution Fund which was ran by the FDIC. The FDIC also administers the Savings Association Insurance Fund (SAIF) that serves as a replacement for the FSLIC as an insurance fund for thrift institutions. Important to note, the OTS, the FHFB, and the FDIC are all separate entities an important distinction from the previous system where the FHLBB controlled the FSLIC which was the institution that insured the banks that it managed. The FHLBB was an independent institution that was enacted by the Federal Home Loan Bank Act while FDIC is much bigger and serves the entire banking system. This important as a major cause of the S crisis was the issue of forbearance. The FSLIC contributed to the accounting fraud that kept these unprofitable or bankrupt institutions afloat. Now, these institutions were seperate which took away from the conflict of interest that the FSLIC had.  Also, FIRREA put in place minimum capital standards. Thrifts must now hold capital equal to 3 percent of their assets.  By requiring minimum capital standards, this ensures a less risky environment for depositors. This is due to the fact, that if an S does not have any net worth, the shareholders do not have anything to lose, which was displayed during the crisis, shareholders will instead encourage the S’s to invest in asset portfolios that may be unprofitable if deposit insurance does not exist. However, with a positive capital, S&L owners actually are liable if the asset portfolio goes under.  FIRREA helps eliminate moral hazard by requiring S&L institutions to hold these minimum levels of capital. By creating these rules, regulators are attempting to meet both the goals of shareholders and the FDIC by preventing insolvency from these institutions taking on excessive credit risk. This minimum capital requirement, serves as a type of insurance deductible that shareholders must pay if they attempt to take advantage of the FDIC deposit insurance. The raised capital requirement and other parts of FIRREA including premium insurance help rid the industry of  “moral hazard:’ that existed during the crisis. These regulations put in place by FIRREA help create a less risky S portfolio environment and have dramatically changed the savings and loan industry, that now encourages loan origination. How Did FIRREA Change the Regulations and Standards of the S Industry? FIRREA drastically changed how the Saving and Loans industry is regulated. The S industry was independently regulated unlike Commercial and Savings banks.  FIRREA is now federally regulated by the FDIC.  FIRREA allowed the FDIC to be apart of the closure process. This was a new responsibility for the FDIC, as FIRREA made it responsible for closing insolvent thrift institutions as well as insolvent banks. FIRREA authorises the FDIC to serve as receiver or conservator for any insured bank or S chartered under federal or state law. This means the FDIC has the ability as a conservator to shut down an institution of concern, while as a receiver it has ability to terminate any activities and liquidate the banks assets. Before FIRREA, the FDIC was able to suspend or terminate deposit insurance coverage at a much slower rate. The minimum period to terminate insurance was more than than two years. After FIRREA was enacted, the process has become much quicker, in some instances as fast as six to seven months. FIRREA in essence gives the FDIC the power to shut down these weak or insolvent financial institutions since it is unlikely that they would survive without deposit insurance. Also, the FDIC in general changed as a result of them getting control of the insurance of Financial Institutions in FIRREA, two years later Federal Deposit Insurance Corporation Improvement Act of 1991 was passed. This policy in response the S crisis now allowed the FDIC to directly borrow from the treasury department.  The FDIC was also now responsible for resolving all banks that failed in the least expensive way possible. As well, the FDIC was now responsible for assessing insurance premiums based on risk and to monitor the new capital requirements. This represents a continuous improvement and need to ensure properly regulated institutions. By giving the FDIC this power it will decrease the likelihood of another crisis.What Financial Institutions Are Affected by FIRREA and How it Was Used During the Great Recession FIRREA affects every Financial Institution as it allows the Justice Department to sue for and enforce civil penalties for any violations of criminal statutes. FIRREA allows the Justice Department to subpoena any document and call any person to trial. Additionally, the Justice Department is able to enact penalties that equal the total gain or loss that occured from the fraud. Today, FIRREA is still used to investigate low quality bank loans and only needs the burden of proof that civil cases need instead of criminal cases that require “beyond reasonable doubt” instead they only need a “preponderance of truth.” This came up during the Great Recession specifically with the Subprime mortgage crisis.   During the crisis the Justice Department used FIRREA to force the six largest banks to pay over $108 Billion in fines and also had these banks buy tens of billions bad mortgage-backed securities that were sold during this time.  FIRREA also prosecuted credit agencies during the crisis for saying that bad loans were good ones. Ethical Consideration and How FIRREA Protects Consumers and Investors Today FIRREA is definitely an act that is a positive step towards bringing ethics to the S industry. Before FIRREA, DIDMCA and Garn-St Germain Depository Institutions Act both created a less ethical atmosphere in the S industry by deregulating it. Risk taking was commonplace among institutions with none to little capital. Many greedy and fraudulent people entered the industry because they thought they could make big profits. They were not held accountable by insurance agencies. FIRREA added premiums and capital requirements that reduce moral hazard in the industry and has led to a less risky S portfolio environment.  These policies under FIRREA have dramatically changed the S industry and now the federal regulation encourages loan origination. Also, by the FDIC being in charge of the insurance aspect this removes forbearance from the industry by having the insurer and examiners as separate entities unlike during the S crisis. Also, FIRREA and the impact of the Sarbanes Oxley Act of 2002 have created full transparency management in the S industry. This now requires these institutions to sign off that their financial statements are correct were previously there was a lot of fraud. If I Was Hired as a Technical Consultant What Are My Major Issues? When looking at the effect that the implementation of the Financial Institutions Reform, Recovery, and Enforcement Act has on the Saving and Loans industry it involves some speculation.  Certainly FIRREA brought more transparency and a more level playing within the banking industry by reducing the industries exposure to moral hazard, increasing closure powers, creating stronger capital standards, and reducing forbearance. However, as a technical consultant, I see room for improvement within FIRREA. Another important aspect is to monitor, is how capital requirements are calculated. Although the raised capital requirements are a positive, the accounting system that calculates these requirements are based on book values accounting instead of market-value accounting. The difference is clearly explained in this example of the housing industry, “if you bought a house 10 years ago for $300,000, its book value for your entire period of ownership will remain $300,000. If you can sell the house today for $500,000, this would be the market value.”  Using book value accounting is risky in the S industry because the risky behavior relates more closely to the market value of capital as book values raise the likelihood that a portfolio may look good on paper. S institutions have the ability under this accounting system to hide its net worth and risky claims from the FDIC. This accounting method presents issues when closing these institutions.  Many book-value insolvent funds can you use different accounting tricks to keep these troubled thrifts to continue to operate and participate in risky activity.  These institutions can operate legally and have growing liabilities. In FIRREA, the growth limits and asset restrictions are also based on book value measures and shows that there are weakness within the closure rules.  The capital provisions within FIRREA make it difficult to tell whether an institution is safe or not.  Although, FIRREA calls for capital standards that are as strict as national banks. However, bank regulations do not use market valuations as well and instead focus on credit risk. An important statistic that needs to be looked at is the risk-adjusted market value net worth which cannot be accurately calculated using book-value accounting which exposes the S’s to interest rate risk, the main cause of the S&L crisis. Due to this, S&Ls ould have the same book value capital ratio but could be two completely different risks for insurance funds. Another of area concern, is how problems with book valuation allow capital forbearance to continue. Although, getting rid of the FSLIC and FHLBB was a positive step towards ridding the industry of forbearance, FIRREA allows for book-value insolvent institutions to continue to operate with permission of the Director of the OTS. Although violators of the new capital standards must put together a capital plan for bringing in additional capital and describe how they will be able to raise new funds, this still leaves space for potential capital forbearance.  Conclusion The implementation of the Financial Institutions Reform, Recovery And Enforcement Act is a right step in bringing more accountability to the Savings and Loans Industry. It makes the lives of consumers easier and significantly reduces the riskiness of Owners and Managers asset portfolios in the S&L Industry. Although, the accounting system still exposes the industry to risk the FDIC’s increased powers bring a level of accountability to the industry that was not previously there. FIRREA brings a much more stable environment to the industry and reduces systematic risk of another crisis.