THE CONTINUING COST OF THE S&L CRISIS: The Law And Economics Of A Vacated $909 Million Judgment Against The Government

The savings and loan (S&L) industry bailout cases continue to be litigated in the courts, decades later. But an appellate decision issued earlier this year, in Glendale Federal Savings Bank, FSB v. United States, may help to bring this chapter in our country's history to its end.

The Glendale decision set aside a $909 million judgment a thrift had won in its suit against the United States. The decision matters not only because of the amount of money at stake, but also because it will help guide trial courts in evaluating claims in more than 100 similar S&L crisis cases.

If the government were to receive adverse decisions, resolution of all these cases could cost taxpayers between 30 and 50 billion dollars, according to estimates by some thrift attorneys. The Glendale decision, however, suggests the damages against the government should be much smaller than that.

In the late 1970s and early 1980s, soaring interest rates wrecked the stability of the S&L industry.

The industry had to pay the going, high interest rates on short-term deposits. At the same time, it received comparatively low payments from mortgage holders, who had locked in a long-term interest rate when rates were lower.

With lots of money going out, and little coming in, it's no wonder that by the early 1980s, nearly all thrifts were insolvent, with the value of their liabilities exceeding their assets. That was not just a problem for the thrifts, but also for the government — which was responsible for regulating the industry.

To deal with the crisis, government regulators decided to adopt a policy of forbearance, taking steps to allow troubled thrifts, which otherwise could have been required to close, to continue to operate. Special accounting techniques — or, according to the Supreme Court, "gimmicks" — allowed both government and industry to wait for interest rates to fall.

This accounting treatment allowed Glendale to merge with Broward and still meet regulatory capital requirements, and appear solvent. Luckily for Glendale, interest rates then declined, and Glendale returned to profitability.

As the 1980s progressed and another savings and loan crisis developed, however, a new law — the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA") was passed. FIRREA had stricter capital requirements, which Congress hoped would lead to more prudent thrift investment.

Among other things, FIRREA prevented Glendale from counting supervisory goodwill as capital for the purpose of government requirements for the full 40-year period that had originally been set.

Glendale was upset by what it believed was a breach of contract and, in 1990, along with other similarly situated thrifts, sued the government. Three of these S&L suits, including Glendale's, were the subject of a 1996 Supreme Court decision.

Glendale said the government had breached the contract by breaking a promise that the supervisory goodwill would count as an asset for regulatory capital purposes for 40 years. The government's position was that regulations constantly change, and Glendale knew it and assumed the risk. Glendale won — but by virtue of a Supreme Court decision that rested, in part, on flawed economic reasoning.

The Supreme Court, acting without the benefit of a detailed evidentiary record, believed that "healthy" thrifts like Glendale acquired "unhealthy" thrifts, thereby solving a problem for the government (taking a troubled thrift off its hands). In exchange, the government provided favorable regulatory treatment (the goodwill promise) that could make the thrift more profitable. But that wasn't really the case.

First, in the early 1980s, there were few economically "healthy" thrifts. And Glendale wasn't one of them. It had been losing money for a number of months before it acquired Broward. Both Glendale and Broward were saved only by the interest rate decline. So Glendale's acquisition of Broward did not do the government, as insurer to both, any favors.

But more loans don't always mean more profits for an S&L — a point that the late, eminent economist and government witness Dr. Merton Miller won the Nobel Prize, in part, for proving. Rather, as the thrift industry learned during the recession of the early 1990s, more loans can lead to more losses, if borrowers default. Strikingly, in the 1990s, when Glendale reduced its size, it also reduced its losses.

After the Supreme Court resolved the liability issue against the government — albeit based in part on flawed economics — the case then went back to the lower courts, where the next question was what damages should be.

A number of prominent experts testified at the Glendale damages trial, including Dr. Miller. The trial court awarded Glendale $909 million. But then in mid-February, the appellate court reversed the judgment.

Unlike the Supreme Court, the appellate court used correct law and economics. Specifically, the appellate court did not conclude — as the trial court did — that Glendale conferred a massive benefit upon the government when it acquired Broward. Accordingly, the appellate court rejected the trial court's massive restitution award, and remanded the case to the trial court for a determination of reliance damages.

Subsequently, an appellate court decision in another S&L case — California Federal Bank, FSB v. United States — provided guidance with respect to the thrifts' claims for lost profits damages. In California Federal Bank, the appellate court did not agree with another trial court's determination that, as a matter of law, the thrift could not prove that its loss of supervisory goodwill caused it to lose profits. California Federal Bank is now entitled to a trial, where it will have the opportunity to substantiate its claim that the FIRREA's phase-out of supervisory goodwill caused it to lose profits.

Even so, good economic logic should prevail for there is no basis for the thrifts to get the huge damages they are seeking. As Dr. Miller remarked at trial in Glendale: "I am reminded of a story that President Reagan used to love to tell about the little boy that was digging through this pile of manure, furiously, and they asked him, 'why are you doing that?' And he said, 'well, I'm sure there must be a pony in there somewhere.'" There is no pony here either, and as the trial courts sift through the evidence, they almost certainly will see that.