Stroke-of-the-Pen Risk: An Historical Perspective
Insured financial institutions are vulnerable to a variety of risks, including
credit, operational, and interest rate risk. For the most part, bank managers
and regulators understand the factors and scenarios that may heighten
these risks and therefore can develop prudent strategies for minimizing
or mitigating a particular institution’s vulnerability. However,
risk also may emerge from unexpected sources, such as changes in accounting
standards, congressional appropriations, macroeconomic developments and
enactment of federal and state laws and regulations. As described in the
FDIC Outlook introduction, this exposure can
collectively be described as “stroke-of-the-pen” risk, as
a single change in policies relating to one area of the economy may bring
unanticipated negative consequences for other sectors—including
banks and savings institutions.
This article focuses
on three historical events that had significant implications for FDIC-insured
financial institutions: a 1979 shift in Federal Reserve
monetary policy that led to dramatic increases in interest rates; enactment
of the Tax Reform Act of 1986; and implementation of Statement of Financial
Accounting Standards No. 125, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. Although significant
debate and deliberation occurred before these changes were enacted, their
implications for insured institutions may not have been fully understood
at the time. Overall, the effects of these regulatory, legislative, and
accounting changes have been positive; however, some specific provisions
complicated the operating environment for banks and thrifts.
A Shift in U.S. Monetary Policy
During the late 1970s, the U.S. economy was characterized by high levels
of inflation, interest rates, and unemployment, a condition referred to
by economists as “stagflation.” While a series of energy price
shocks had contributed to rising inflation during the 1970s, by the end
of the decade there was also recognition that reforms were needed in the
way the Federal Reserve conducted monetary policy.1
The Federal Reserve’s policy had been to target—or to seek
to preserve stability in—the level of short-term interest rates,
with the expectation that doing so would stabilize economic activity.
However, prices rose and inflationary expectations began to become firmly
entrenched in household, business, and investor decisions. The high inflation
rate tended to distort the economic decisions made by all of these groups,
impairing the overall performance of the economy.
Because of this economic scenario, the Federal Open Market
Committee (FOMC), in an historic session held on October
6, 1979, approved a fundamental shift in its monetary policy strategy.
The new strategy switched the Federal Reserve’s immediate focus
from targeting short-term interest rates to achieving stability in the
growth of monetary reserves and, hence, the supply of money. This shift
in operating procedure effectively meant that monetary policy would no
longer attempt to cushion the blow of economic shocks, such as a sharp
rise in oil prices, at the cost of allowing inflation to rise. Instead,
the Federal Reserve pursued a longer-term goal of price stability by emphasizing
controlled growth in monetary reserves and the money supply.
The shift in policy necessitated an immediate and dramatic rise in U.S.
short-term interest rates. The federal funds rate quickly rose from an
already high 11.4 percent in September 1979 to 13.8 percent in October,
and to 17.2 percent by March 1980.2 This change
in interest rates was deemed necessary in part to curtail expectations
of ever-rising consumer prices, which increased at a year-over-year rate
of 11.7 percent in the third quarter of 1979.
In terms of containing inflation, the policy change was considered an
unqualified success. The inflation rate peaked at 12.9 percent in the
third quarter of 1980. Within three years, consumer price inflation fell
to just 2.5 percent.3 But the impact on the
U.S. economy was severe. Back-to-back recessions in 1980 and 1981–82
drove the U.S. unemployment rate to a post-Depression high of 10.8 percent
by the end of 1982. It was not until September 1987 that the unemployment
rate fell to where it had been when the FOMC instituted its October 1979
Perhaps less widely
appreciated at the time was the effect that high and volatile short-term
interest rates would have on financial institutions, particularly thrift
institutions insured by the Federal Savings and Loan Insurance
Corporation (FSLIC). The predominant business model for
thrifts up to that time was to originate and hold long-term, fixed-rate
mortgage loans, funding them primarily with savings deposits of somewhat
shorter duration. Through most of their history, this basic strategy had
produced steady, if unspectacular, earnings results (see Chart 1). The
industry’s return on assets averaged 0.62 percent during the 1970s
and measured 0.64 percent in 1979. However, by this measure, industry
profitability in 1980 declined by four-fifths, to just 13 basis points.
The thrift industry as a whole lost $4.6 billion in 1981 and $4.3 billion
in 1982.4 On a before-tax basis, an additional
$1.5 billion a year in losses would have occurred during this period.5
The financial problems that began for the thrift industry in 1980 coincided
with the sudden spike in interest rates associated with the change in
Federal Reserve policy. While the long-term mortgage assets held by thrifts
continued to pay steady streams of interest, their market value deteriorated
as interest rates rose. Meanwhile, the shorter maturity deposit liabilities
used to fund thrift balance sheets were quickly becoming much more expensive.
As short-term deposits matured, thrift managers were left with an unenviable
choice: to either liquidate their mortgage holdings and realize a capital
loss, or fund them with market-rate deposits and incur operating losses
as long as rates remained high.6 Given its
relatively monolithic business model at the time, with its built-in vulnerability
to spikes in interest rates, the thrift industry continued to incur losses
as long as high interest rates persisted. Chart 2 shows that the average
net worth of the thrift industry declined for six consecutive years after
1979, falling by more than half to just 2.7 percent. By 1981 the gap between
book value and market value of the thrift industry’s net worth exceeded
$86 billion, making the industry as a whole insolvent on a market-value
Legislators, regulators, and thrifts initiated actions in the early 1980s
intended to limit or in some cases recoup the losses resulting from the
interest rate spike. Congress passed legislation in 1980 to gradually
relax the Regulation Q ceilings on deposit interest rates, so that thrifts
could offer competitive market rates to attract and retain deposit funding.
This move helped to solve one problem for the industry: disintermediation,
or the outflow of deposits as savers found higher returns in new instruments
(such as money market mutual funds) that paid market rates of return.
It did not, however, solve the earnings problems resulting from rising
deposit costs and shrinking net interest margins. The thrift industry’s
net interest income for 1981 was a negative $1.8 billion (–0.28
percent of assets), which deteriorated to a negative $4.2 billion (–0.61
percent) in 1982.8
Although the thrift industry was losing money rapidly, there was the possibility
that a decline in interest rates and a steepening of the yield curve could
help thrifts become profitable if they occurred soon. A range of forbearance
policies enacted by federal bank and thrift regulators in the early 1980s
were designed to give the industry extra time to address its financial
problems. These policies included a lowering of regulatory net worth requirements,
a net worth certificate program that helped undercapitalized financial
institutions meet their capital requirements, and adjustments to accounting
policies to allow institutions to defer losses into the future.9
Legislation enacted in 1982 also allowed thrifts to engage in new types
of lending activities that promised to boost asset yields and limit exposures
to future interest rate spikes. These new powers included, most notably,
the ability to fund commercial real estate (CRE) loans and, under certain
conditions, to make equity investments in CRE enterprises. In the generally
adverse financial climate facing the thrift industry at that time, a number
of institutions significantly expanded their activities in these nontraditional
areas. Nonmortgage loans held by FSLIC-insured institutions more than
doubled as a percentage of assets between 1982 and 1986, from 3.0 percent
to 6.5 percent. But these new investment powers were not a panacea for
the industry. While they helped to mitigate the interest-rate risk exposures
that had produced the losses of 1980–81, they significantly raised
the credit risk profile of many thrifts, leading to even larger problems
in the mid- to late 1980s.
A number of studies have documented the roles played by regulatory forbearance
and deregulation in contributing to the eventual failure of hundreds of
insolvent thrift institutions in the 1980s and early 1990s and the insolvency
of the FSLIC itself in 1989.10 Some studies
also emphasize the interest rate squeeze of 1979–1981 as the prime
mover of the ultimate thrift industry debacle.11
A prominent role was also played by the economic adversity associated
with the energy industry in the Southwest, the defense industry in New
England, and the “rolling regional recession” that depressed
commercial real estate markets and imposed large losses on banks and thrifts
in both regions. Perhaps it is in part the sheer magnitude of these later
losses—2,420 federally insured banks and thrifts failed between
1985 and 1993—that tends to overshadow the role played by the initial
interest rate shock in pushing the thrift industry toward its later financial
The Tax Reform Act of 1986 (Tax Act)
The 1986 amendment to federal tax laws on real estate investments represents
a prime example of how a policy change can affect financial institutions.
With the stroke of a pen, this legislation eliminated the ability to offset
passive losses with nonpassive income; increased the capital gains tax
rate from 20 to 28 percent; and reinstated straight-line depreciation,
dampening demand for CRE investment and putting downward pressure on real
estate prices. Ultimately, this legislation tended to depress real estate
market values in the late 1980s, which in turn contributed to the subsequent
failures of financial institutions with relatively large concentrations
in real estate development loans.
In some sense, the Economic Recovery Act of 1981 set the stage for enactment
of the Tax Act of 1986, as it lowered marginal tax rates and changed the
capital gains rules and depreciation schedules for real estate investments.
The 1981 Act allowed investors to recoup their initial investment quickly
through tax losses alone, which resulted in real estate investments becoming
a favored federal tax shelter. The growing popularity of real estate was
reflected on financial institutions’ balance sheets. For example,
in 1980, commercial bank real estate loans as a percentage of total loans
was 18 percent. Five years later, this amount had jumped to 27 percent.
The Tax Act of 1986 wiped out the 1981 tax advantages and made sweeping
changes in the treatment of personal and corporate income. (See Table
1 for a comparison of the tax changes made throughout the 1980s.) The
legislation eliminated many tax deductions and tax preferences and changed
the tax treatment of bad debt reserves and tax-exempt securities. Previously,
taxpayers generally could use losses and credits from one activity to
offset income from another activity. Following enactment of the Tax Act,
taxpayers could not use losses and credits to offset income from another
activity; instead, passive losses and credits had to apply to other passive
income.12 CRE now became a relatively higher
risk investment because the federal government would no longer share the
losses of unsuccessful investments.13 Rental
real estate income earned by proprietors and partnerships would be treated
as corporate income, and be fully taxed if positive. As a result, investors
began to ask higher rents on real estate investments to compensate for
higher taxes. The after-tax internal rate of return declined under the
Tax Act; much of the difference can be attributed to the elimination of
depreciation deductions that had been allowed under the 1981 tax bill.
|Major Tax Law Provisions Affecting Returns on Commercial Real Estate Investment
the Economic Recovery Tax Act of 1981
Reform Act of 1986
commercial real estate
income tax rate
gains tax rate
FDIC, History of the Eighties, Lessons for the Future.
Overall, the 1986
tax legislation tended to depress real estate values because of changes
in the depreciation schedule. Under the depreciation provisions in the
1981 tax law, the after-tax return of CRE investments had increased relative
to other assets. The Tax Act of 1986 eliminated this favorable depreciation
schedule. As a result, demand for real estate declined and the value of
real estate fell. According to the FDIC’s History of
the Eighties, Lessons for the Future, $16 billion was invested
in real estate limited partnerships in 1985; by 1989, this amount had
declined to $1.5 billion. In addition, the quality of banks’ real
estate loans deteriorated, with nonperforming loans rising from 3.1 percent
in 1984 to 4.8 percent in 1990 (see Table 2). The 1980s ended with a two-year
total of 406 failed banks that held $64.9 billion in assets.14
Real estate losses contributed significantly to these bank failures, costing
the FDIC billions of dollars in resolution costs and leading to the FDIC’s
first annual operating loss. The FDIC and the Resolution Trust
Corporation eventually became the nation’s largest
real estate sales organizations because of the inventories acquired from
failed banks and thrifts in areas where real estate values fell precipitously.15
To be sure, changes in the tax laws were not the only—and were perhaps
not the primary—cause of the bank and thrift losses in CRE loans
in the late 1980s and early 1990s. However, the changes were a well documented
contributing factor. This situation shows clearly the effects of a stroke-of-the-pen
legislative policy change, and reinforces the need for bank management
to closely monitor all implications of key tax legislation.
|Nonperforming Real Estate Loans Rose as a Percent of Total Loans After 1986, As Did Net Charge-Offs
Data are not available for years before 1984.
*Nonperforming loans include loans 90 days past due, non-accruing
loans, and repossessed real estate.
Source: FDIC, History of the Eighties, Lessons
for the Future.
of Financial Accounting Standards No. 125—Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities16
In 1996, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards No. 125 (FAS 125) to provide guidance
for distinguishing between the transfers of financial assets that should
be reported as sales and transfers that should be reported as borrowings.
During the early 1990s, the FASB acknowledged that the market’s
increasingly complicated financial assets made it difficult to determine
when transferred financial assets should be removed from the balance sheet
and a related gain or loss recognized, and announced efforts to develop
plans for an approach that would achieve consistent, credible, and understandable
The FASB recognized that financial assets and liabilities can be divided
into several categories, such as servicing rights, residual interests,
recourse obligations, and pledges of collateral. When accounting for transfers
of financial assets, particularly those related to securitizations of
assets, concerns arose about whether transactions represented a sale,
which would result in the reporting of a gain or loss on sale, or a secured
borrowing. Unless accounted for correctly, securitizing assets can make
companies appear more profitable than they are and overstate capital levels,
while the risks that are often concentrated in the interests that an entity
retains in the securitized assets may not have been properly considered
in the measurement process. In another stroke-of-the-pen policy change,
FAS 125 required that the fair values of retained interests enter into
the accounting for securitizations that qualified as sales, thereby affecting
the size of the gain or loss on the sale. In the absence of quoted market
prices, which was typically the case with retained interests, companies
had to estimate the fair value of these interests and support the estimated
fair value with documentation using reasonable and supportable assumptions.
FAS 125 proved to be quite complicated, and it became clear that more
guidance was needed. In September 1998, December 1998, and July 1999,
the FASB issued “Question and Answer” implementation guidance
on FAS 125. In addition, in December 1999, the federal bank regulatory
agencies issued the Interagency Guidance on Asset Securitization Activities,
which included discussion of valuations of retained interests in securitizations
accounted for in accordance with FAS 125. The interagency guidance emphasized
the agencies’ expectation that retained interests held as assets
would be supported by documentation of the interests’ fair values,
using reasonable, conservative valuation assumptions that could be objectively
The pitfalls of inaccurately accounting for securitized assets were obvious
in the situation of Superior Bank FSB.17
Starting in 1993, Superior Bank originated and securitized large volumes
of subprime residential mortgages and retained residual assets that were
a by-product of the securitizations. Residual interests represent claims
on the cash flows that remain after all obligations to investors and any
related expenses have been satisfied.18 In
1994, Superior expanded its securitizations activities to incorporate
subprime automobile lending. Superior’s concentrations of residual
assets to tangible capital rose from 122 percent at year-end 1995 to 268
percent at year-end 1999.
Because there was not a ready market for these assets, Superior valued
its residual interests using a model. The model was based on the thrift’s
assumptions of default rates and prepayment rates on the portfolio of
loans underlying the securitizations and discount rates.19
According to the FDIC Office of Inspector General’s report on the
failure of Superior, the thrift booked large imputed gains based on liberal
interpretations of FAS 125.20 For example,
the thrift used unsupported discount rates, and at one point lowered the
discount rate by 400 basis points, resulting in a substantial gain. Superior
also chose a method of accounting that did not require discounting of
funds providing credit enhancement to securitizations, even though those
funds were not immediately available to the thrift.21
The large imputed gains augmented capital and allowed the thrift to continue
to lend and securitize.
In 2000, regulators noticed that, although some institutions had shown
downward adjustments to reflect the application of the guidance in the
1998 FASB Questions and Answers, Superior’s financial data did not
have such adjustments.22 The Office
of Thrift Supervision, with FDIC participation, scheduled
an on-site visitation in October 2000 to review residual assumptions,
and the agencies focused on residuals at a subsequent examination in March
2001. After examiners found the thrift had not properly discounted cash
flows and had used other unsupported assumptions, they determined that
the thrift’s assets were overvalued by at least $420 million as
of December 31, 2000.23
When federal regulators required Superior Bank to restate its financial
data, the institution was deemed significantly undercapitalized and failed
shortly thereafter. At the time of its failure, Superior had $1.7 billion
in total assets, of which $842 million were residual assets. The failure
cost to the FDIC was an estimated $426 million.
The business strategies, investment choices, and risk management decisions
of financial institutions are necessarily based on the current economic,
accounting, legislative, and regulatory situation, as well as the possibility
that this situation may change. However, management can never anticipate
all scenarios or the unintended negative consequences that could arise
from sweeping policy changes.
The three historical “stroke-of-the-pen” events addressed
in this article show the dramatic effects policy changes can sometimes
exert on the operating environment of financial institutions. The 1979
shift in U.S. monetary policy was successful in containing inflation and
contributed to much improved U.S. economic performance in the 1980s and
1990s. But at the time it was introduced, the full effects of this policy
change, in tandem with other domestic and international economic events,
were difficult, if not impossible, for financial institution managers
and regulators to anticipate. Similarly, the changes mandated by the Tax
Reform Act of 1986 brought about significant adverse consequences for
insured financial institutions with exposure to CRE loans. The elimination
or tightening of real estate tax deductions and preferences contributed
to a serious downturn in the CRE market and eventually to failures of
insured financial institutions with relatively high CRE portfolio concentrations.
Finally, the accounting changes of FAS 125, although developed and implemented
to improve the clarity, consistency, and transparency of financial statements,
had the unintended effect of potentially complicating accounting procedures
for securitized assets, as the example of Superior Bank demonstrates.
The point of emphasizing these episodes of systemic, “stroke-of-the-pen”
risk is not to portray them as unmanageable, catastrophic events. As with
any other class of risks, bank managers assume ultimate responsibility
for monitoring changes in the policy environment and managing their institutions’
exposure to these changes. The point is for risk managers to attempt to
anticipate the possible consequences of policy changes as early as possible,
and to recognize the possibility that such changes may have sweeping effects
on their institutions. These episodes show that, despite substantial debate
and discussion before the fact, the enactment of policy changes may have
unforeseen effects on financial operations, and their negative results
can be considerable. While every implication of a policy change cannot
be known in advance, management is best served by a business strategy
that is watchful for and responsive to such changes.
Axilrod, Stephen H. 1985. U.S. Monetary Policy in Recent
Years: An Overview. Federal Reserve Bulletin, 71:14-24.
Benston, George J. 1985. An Analysis of the Causes of
Savings and Loan Association Failures. Salomon Brothers Center for the
Study of Financial Institutions Monograph Series in Finance and Economics,
Federal Deposit Insurance Corporation (FDIC). 1982. Annual
Report of the FDIC for the Year Ended December 31, 1982. FDIC.
Federal Reserve Bank of St. Louis. 2005. Conference Proceedings:
Reflections on Monetary Policy 25 Years After October 1979. FRBSTL Review
87. March/April 2:137-358.
Follain, James R., Patric H. Hendershott, and David C. Ling. 1987.
Understanding the Real Estate Provisions of Tax Reform: Motivation and
Impact. National Tax Journal 40, 3:363-372.
Johnson, Christian A. 2004. The Failure of Superior Bank
FSB: Regulatory Lessons Learned. Banking Law Journal 121, 47:1-13.
Neuberger, Jonathan A. 1988. Tax Reform and Bank Behavior.
Federal Reserve Bank of San Francisco Weekly Letter December 16, 1-3.
Seballows, Lynn D., and James B. Thomson. 1990. Underlying
Causes of Commercial Bank Failures in the 1980s. Federal Reserve Bank
of Cleveland Economic Commentary September 1, 1-4.
U.S. General Accounting Office. Bank Regulation: Analysis
of the Failure of Superior Bank, FSB, Hinsdale, Illinois. GAO/02-419T.
February 7, 2002.
Volcker, Paul A. 1981. Statement before the Committee on Banking,
Housing, and Urban Affairs. Federal Reserve Bulletin, 67:237-241.
Richard A. Brown, Chief Economist
Jane F. Coburn, Senior Financial Analyst
Christopher J. Newbury, Chief, Financial Analysis Section
1. See Black, Robert P. March/April 2005. Reflections on the October 6, 1979, Meeting of the FOMC. Review—Federal Reserve Bank of St. Louis, vol. 87, no. 2, 307.
2. Source: Federal Reserve Board, calculated as a monthly average of rates on trades through New York brokers.
3. U.S. Bureau of Labor Statistics, as of third quarter 1983.
4. Federal Home Loan Bank Board, April-May1988. Staff Report to the Senate Committee on Banking, Housing, and Urban Affairs, 37.
5. Eichler, Ned. 1989. The Thrift Debacle. Los Angeles, CA: University of California Press, 71.
6. White, Lawrence J. The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation. New York: Oxford University Press, 70.
7. Carron, Andrew S. 1982. The Plight of the Thrift Institutions. Washington, DC: The Brookings Institution, 19.
8. Federal Home Loan Bank Board. Staff Report to the Senate Committee on Banking, Housing, and Urban Affairs, 32a.
9. See White. 82-83.
10. See Federal Deposit Insurance Corporation. 1997. Chapter 4: The Savings and Loan Crisis and Its Relationship to Banking. In History of the Eighties, Lessons for the Future. Washington, DC: FDIC.
11. See Benston, George J. 1985. An Analysis of the Causes of Savings and Loan Association Failures. Salomon Brothers Center for the Study of Financial Institutions Monograph Series in Finance and Economics, 4/5, 171.
12. Nixon, Hargrave, Devans, and Doyle. 1986. The Tax Reform Act of 1986. Philadelphia: American Law Institute—American Bar Association, F-5.
13. Passive activity is defined as any business, rental, or trade activity in which the taxpayer does not materially participate.
14. Annual Report of the FDIC for the Year Ended December 31, 1990, 77.
15. The Resolution Trust Corporation was created to handle former Federal Savings and Loan Insurance Corporation institutions that became insolvent.
16. In general, FAS 125 applied to transfers of financial assets occurring after December 31, 1996, through the end of the first quarter of 2001, when it was replaced by Statement of Financial Accounting Standards No. 140 (FAS 140), which applies to transactions occurring after March 31, 2001. FAS 140 revised certain aspects of the accounting for securitizations and other financial asset transfers in FAS 125 and required additional disclosures, but it carried over most of the provisions of FAS 125.
17. Superior Bank FSB, Hinsdale, Illinois. Superior Bank was a federally chartered savings bank outside of Chicago that was regulated by the Office of Thrift Supervision, with deposits insured by the Savings Association Insurance Fund. Superior Bank failed in July 2001.
18. FDIC Office of Inspector General. Issues Related to the Failure of Superior Bank, FSB, Hinsdale, Illinois. Audit Report No. 02-005, 18.
20. FDIC Office of Inspector General. Audit Report No. 02-005. 4.
21. FDIC Office of Inspector General.Audit Report No. 02-005. 15-16.
22. Department of the Treasury, Office of Inspector General. February 6, 2002. Material Loss Review of Superior Bank, FSB. Audit Report OIG-02-040, 28.
23. FDIC Office of Inspector General. Audit Report No. 02-005. 24-25.