United States General Accounting Office 

Testimony 

For Release 

on Delivery 

Expected at 

10 a.m. EDT 

Thursday 

May 19, 1988 

The Federal Savings and Loan Insurance 

Corporation --Current Financial Condition 

and Outlook 

Statement of 

Frederick D. Wolf, Director 

Accounting and Financial Management Division 

Before the 

Committee on Banking, Housing and Urban Affairs 

United States Senate 

pQ\q \ - 

GAO/T-AFMD-88-12 GAO Form 180 (12/87) 
Mr. Chairman and Members of the Committee: 

We are pleased to appear today to discuss the results of our 

audit of the Federal Savings and Loan Insurance Corporation's 

(FSLIC) 1987 financial statements, the insurance fund's precarious 

financial condition, and FSLIC's and the Federal Home Loan Bank 

Board's ability to resolve the growing threat to the insurance fund 

and savings and loan (S&L) industry presented by the increasing 

number of insolvent and inadequately capitalized institutions. I 

would first like to provide some background on how a large segment 

of the industry got into this critically deteriorated financial 

condition, which will serve to underscore the seriousness and 

magnitude of the problems the troubled sector of the S&L industry 

faces and provide perspective on the resources FSLIC needs to deal 

with problem institutions. 

THE SAVINGS AND LOAN 

INDUSTRY'S TRANSFORMATION 

For over 40 years, the thrift industry operated in a 

relatively simple and safe environment in which deposits generated 

from the local economy at regulated interest rates were invested in 

traditional home mortgages. However, during the last decade, that 

simple environment has disappeared as the industry has struggled to 

remain competitive and profitable. During this time, 

-- restrictions on interest rates that could be paid on 

deposits were progressively lifted, 

-- competition for deposits escalated, 

-- S&Ls had to pay increasingly higher interest rates to 

preserve their core deposits at the same time that they 

were encumbered with low-yielding loan portfolios, 

-- S&Ls were permitted to expand their operations into assets 

traditionally reserved for banks, such as commercial and 

consumer lending, and 

-- various states dramatically expanded the types and extent 

of investment activities in which state-chartered S&Ls 

could participate. 

Diversification Into 

Non-traditional Assets 

The expansion of asset and investment activities is 

particularly noteworthy. Many thrifts began to diversify their 

asset portfolios away from traditional residential mortgage loans 

and into other potentially more profitable but possibly riskier 

activities, many of which were predicated upon continued increases 

in real estate values to make them economically viable. Such 

activities included: 
-- acquisition, development, and construction loans, with S&LS 

often providing 100 percent financing, and on which payment 

depends upon a project being completed and achieving 

profitability; 

-- direct investment in real estate and equity securities, 

profit on which generally depends upon economic factors 

beyond the thrifts' control; 

-- land speculation; and 

-- participation loans on which S&Ls often used lax 

underwriting standards, with the participating SLLs relying 

on the loan originator to adequately evaluate the soundness 

of the loans. 

While such activities are potentially more lucrative than 

traditional home mortgage loans, they require expertise that many 

S&Ls did not have. Moreover, returns from these ventures are more 

volatile than traditional home mortgages and such activities are 

among the first affected by economic downturns. 

Non-traditional 

Funding Sources 

To fund these potentially more lucrative, but possibly riskier 

activities and to fund rapid growth --which was often erroneously 

assumed to equate to higher profits --many S&Ls began to rely to a 

greater extent on non-traditional sources of funds. Specifically, 

many S&Ls began selling their traditional home mortgage loans, thus 

eliminating a stable source of income. Accepting brokered deposits 

also became a widespread means of obtaining funds, especially by 

troubled thrifts willing to pay a premium to get funds needed to 

continue operating. Such funds are not only costly but also are 

usually very volatile, shifting from one institution to another to 

obtain a higher rate of return. Thus, if such funds are withdrawn, 

as brokered deposits often are, an already troubled S&L's financial 

condition could be critically affected. 

Imprudent and Dishonest 

Operators Enter Market 

Compounding the problems resulting from rapid asset 

diversification and from the high cost of rapid growth was the 

entry of some imprudent and dishonest operators into the S&L 

industry. Many of these "high fliers" used their SCLs as private 

piggy banks to finance lavish lifestyles and to engage in 

speculative business activities. Failing to follow Bank Board 

regulations, including those pertaining to insider loans and loans 

to a single borrower were evident in many of the largest S&L 

failures. 

2 
Impact on the Supervisorv Process 

As a result of the industry's rapid transformation, 

supervisory and examination personnel became responsible for 

monitoring a diversified and complex industry engaged in 

sophisticated and often unprecedented financial activities. At the 

same time, the Bank Board's supervisory and examination activities 

suffered from high employee turnover and staff inexperienced in the 

new, complex activities of thrifts. Moreover, until 1985, due in 

large part to hiring and salary limitations, the Bank Board was 

unable to increase the size of its staff to deal with the newly 

deregulated and rapidly expanding industry. This combination of 

factors served to exacerbate an already troubled situation in the 

industry by potentially delaying recognition of problems at an 

early stage when they possibly could have been contained. 

Economic Downturn in Certain 

Sectors of the Economy 

Perhaps the most damaging blow to the savings and loan 

industry was the economic downturn in the agricultural and, more 

importantly, the oil and gas sectors of the economy. The dramatic 

increase in energy prices in the early-1980s fueled tremendous 

growth and rapid inflation of real estate values in the Southwest. 

However, the equally dramatic and rapid decline in energy prices in 

the mid-1980s caused the bottom to fall out of the real estate 

industry in that area of the country. This drastic decline in real 

estate values substantially altered the savings and loan industry's 

financial condition and accelerated its downward slide. 

THE S&L INDUSTRY'S 

FINANCIAL CONDITION 

Diversification into riskier activities, high cost of funds, 

and insufficient supervision, coupled with severe economic downturn 

in certain sectors of the economy, have left many thrifts with 

little except enormous losses from their poor quality assets. 

While rapidly declining interest rates began to correct the 

interest rate spread problems of the late-1970s and early-1980s, 

S&Ls began having to absorb substantial losses on their loans and 

investments. The outcome has been an alarming number of S&L 

failures, and a large segment of the industry saddled with asset 

quality problems. Although almost two-thirds of the industry was 

profitable in 1987, earning $6.6 billion, these profits were far 

outweighed by the $13.4 billion loss experienced by the remaining 

one-third of the 3,147 FSLIC-insured institutions, located 

primarily in the Southwest. In addition, although 211 SCLs were 

closed or merged between 1983 and 1987, at the end of 1987, over 

500 insolvent institutions with negative net worth of $18 billion, 

as measured by generally accepted accounting principles, were still 

operating. An additional 435 institutions with assets of 

$255 billion were barely solvent, with net worth ratios between 

3 
0 and 3 percent. For your information, we are providing two tables 

that show in detail the condition of the thrift industry. (See 

attachments I and II.) 

Over the past 2 years, the Federal Home Loan Bank Board has 

acted to limit S&Ls' and FSLIC's exposure to certain investments 

and loans. Specifically, the Bank Board has increased the 

supervisory and examination staff and has adopted regulations to 

limit direct investments and certain highly risky loans, increase 

capital requirements, and require S&Ls to begin reporting in 

accordance with generally accepted accounting principles. While we 

support the Bank Board's actions, and believe they may minimize 

future losses related to such activities, these actions were too 

late to reduce the enormous problems the industry and FSLIC face. 

In addition, it now appears that S&Ls are entering into newer 

and more complex financial transactions that potentially expose 

FSLIC to additional significant risks. These transactions include 

risk controlled arbitrage, in which some institutions fund rapid 

growth by using short-term liabilities to add long-term assets. 

While such arrangements offer potentially higher returns, they also 

carry commensurate risk and require a high level of expertise to 

manage. Also, recently, an investment firm attempted to create new 

financial instruments-- Real Estate Mortgage Investment Conduit 

certificates created from "underwater mortgages." This transaction 

was intended to enable financial institutions with below market 

yield mortgage-backed securities or mortgages to "sell" these 

assets and, surprisingly, record a gain on the sale. While it 

appears this scheme never got off the ground, the potential for 

developing other "creative" transactions exists. Any new 

activities, especially complicated financial instruments and 

arbitrage schemes, require a great deal of expertise, and are not, 

by any stretch of the imagination, risk-free. Nor are they a quick 

and easy solution to the industry's financial woes. Instead, if 

not adequately monitored and controlled, they may do much more harm 

than good. 

FSLIC'S CURRENT FINANCIAL CONDITION 

We have just completed our audit of FSLIC's 1987 financial 

statements and will be issuing our report on that audit shortly. A 

copy of our opinion, which will be delivered to the Corporation, 

and a summary of FSLIC's financial statements are attached to this 

statement. (See attachments III and IV.) These statements 

indicate continuing deterioration of FSLIC's financial condition, 

and raise serious questions about its ability to deal with the 

industry's still growing problems. 

During 1987, FSLIC had a net operating loss of $8.6 billion, 

resulting in a $13.7 billion deficit--more than double its 1986 

deficit. FSLIC's operating loss was primarily attributable to the 

$6.9 billion increase in its liability for failed but still 

4 
operating thrift institutions, as Well as $3.5 billion in losses 

for institutions that have received financial assistance or have 

already closed. 

1987 Loss Provision for Unresolved Cases 

The attached summary financial statements reflect a liability 

of more than $17 billion for resolving the problems of the more 

than 200 insolvent institutions for which FSLIC has assumed 

responsibility and for several others FSLIC expects to deal with in 

1988. This liability increased by $6.9 billion in 1987 due to the 

growing number of critically distressed open thrifts and to the 

increasing cost related to resolving their problems. During 1987, 

FSLIC's caseload of seriously troubled thrifts increased from 183 

to 205 and included 138 thrifts that were in its 1986 caseload. 

These thrifts continued to incur large operating losses, thus 

further increasing FSLIC's eventual resolution costs. 

While some have suggested that these losses are not "real" 

but only contingent in nature, we would dispel that myth. The term 

"contingent" in no way applies to the loss estimates developed for 

FSLIC's caseload. The institutions involved have incurred actual 

losses, as evidenced by their negative tangible net worth, and 

FSLIC's costs to resolve institutions' problems have historically 

exceeded negative tangible net worth. The fact that FSLIC cannot 

resolve all cases for several years does not diminish its 

liability. Instead, experience clearly shows that delaying 

resolution will increase FSLIC's ultimate costs by allowing these 

institutions to continue incurring losses. In this regard, the 

industry reported further capital losses of $3.3 billion in the 

first quarter of 1988. 

The $17 billion liability at December 31, 1987, is not a 

projection of the cost to resolve all known problems in the 

industry. Instead, as previously noted, it is primarily the 

estimated cost to resolve the problems of those insolvent 

institutions for which FSLIC had assumed responsibility. At 

December 31, 1987, almost 300 additional institutions with assets 

of about $88 billion were insolvent, exposing FSLIC to further 

risk. A precise estimate of the eventual cost to resolve problems 

of those additional institutions cannot presently be made because 

the cost depends upon various uncertainties, such as the quality of 

each institution's assets, future interest rates, and the economic 

outlook for certain sectors of the economy in which many of the 

troubled institutions operate. FSLIC believes that the negative 

tangible net worth of those institutions indicates that the cost 

will be at least $5.3 billion. We believe that this estimate may 

substantially understate the magnitude of financial assistance the 

StLs will need for two reasons--probable future operating losses 

and historical experience. We expect these S&Ls, which have been 

incurring losses and which FSLIC will not act on for several years, 

to incur future losses, thus increasing the eventual costs FSLIC 

5 
must absorb. In addition, the historical costs of resolving SbLs' 

problems have consistently exceeded the reported negative tangible 

net worth of those institutions. Over the last 3 years, 

liquidating and merging S&Ls cost FSLIC, on average, more than 

20 percent of an institution's assets and generally exceeded 

negative tangible net worth by almost 70 percent. Estimates of 

FSLIC's ultimate cost to deal with these additional StLs, using 

historical factors, would indicate a potential cost for the 300 

additional institutions substantially in excess of the currently 

reported $5.3 billion negative tangible net worth, and range from 

$9 to $19 billion. 

1987 Loss Provision for Resolved Cases 

During 1987, FSLIC paid off or transferred insured depositors' 

accounts in 17 insurance actions. As a result, FSLIC made claims 

of $2.8 billion against the closed institutions' assets, which were 

transferred to receiverships for liquidation at the time the S&Ls 

were closed. However, because the loans and real estate of the 

failed thrifts are of extremely poor quality, FSLIC only expects 

to recover 39 percent of its claims from the sale of assets of 

institutions liquidated in 1987. In total, at December 31, 1987, 

FSLIC had $11.6 billion in claims against all receiverships, of 

which it expects to recover only $4.9 billion, or 42 percent of its 

claims. 

In addition, in 1987, FSLIC losses related to assistance 

agreements for the merger or acquisition of failed thrifts 

increased by more than 150 percent over the previous year. FSLIC's 

1987 loss provision of $1.7 billion includes the estimated cost of 

the 31 institutions merged or sold in 1987, as well as adjustments 

to estimated costs of prior years' mergers and acquisitions. 

Between 1981 and 1987, FSLIC spent a total of $4.6 billion to 

provide such assistance. However, this expenditure may not reflect 

final resolution costs for those institutions. Some mergers have 

resulted in institutions so poorly capitalized that further costly 

action may be necessary. For example, four institutions that 

acquired failed thrifts with FSLIC assistance during 1987 had 

negative tangible net worth at the end of the year. 

OUTLOOK FOR RESOLVING THE 

INDUSTRY'S PROBLEMS 

As previously noted, a significant number of SCLS are 

insolvent and continue to incur sizable losses. The problems of 

these institutions are of such magnitude they clearly cannot be 

resolved without substantial financial assistance. At the same 

time, FSLIC's financial condition and, thus, its ability to provide 

such assistance, is severely distressed. Nonetheless, FSLIC 

believes that it will have the resources available to effectively 

resolve the industry's problems, and has provided us with a lo-year 

6 
projection of funds it expects to have available, and the 

corresponding outlays it expects to incur. 

Over the next 10 years, FSLIC expects to have about $28 billion 

in net new funds from regular and special assessments and from the 

sale of bonds authorized by the Competitive Equality Banking Act of 

1987 (CEBA), as well as from the sale of assets from existing 

receiverships available for resolutions. However, in developing 

its projection, FSLIC has made several assumptions that are 

relatively optimistic and, as with any projection, may prove 

incorrect. We have carefully reviewed the projection and its 

underlying assumptions and have concluded that, while FSLIC has the 

resources to continue operating in the near future, it may not have 

sufficient resources to effectively deal with the industry's 

current and future problems. 

Ability to Merge Rather Than Liquidate 

Implicit in FSLIC's forecast is the expectation that almost 

all of the problem institutions can be dealt with by merging them 

with other, presumably healthier, thrifts, rather than liquidating 

them. Using these assumptions results in a lower cost than if more 

liquidations were expected because, historically, it has been 

significantly less costly for FSLIC to arrange for a troubled 

institution's assets and liabilities to be assumed by another, 

financially strong institution rather than close an institution and 

pay off its insured depositors. Specifically, between 1985 and 

1987, merger costs were 16 percent of the merged institutions' 

assets, while liquidation costs were 49 percent of the 

institutions' assets. 

Unfortunately, the premise that almost all of the industry's 

problem cases can be resolved through mergers is inconsistent with 

resolution actions over the past 5 years. Of 179 transactions 

FSLIC completed during that period, 66, or 37 percent, were 

liquidation-type transactions, while 113 were mergers or 

acquisitions. Recent activity does not indicate a trend toward 

mergers. Between January 1, 1988 and April 30, 1988, FSLIC 

accomplished 22 transactions--10, or 45 percent, were 

liquidations, and 12 were mergers or acquisitions. While FSLIC and 

the Bank Board may hope to accomplish more mergers in the future, 

we do not believe that in prior years they would have chosen 

liquidation --the more costly form of resolution--if a merger would 

have been cheaper and equally effective. 

The Bank Board has stated that a large number of potential 

investors have expressed interest in acquiring thrifts with FSLIC 

assistance. However, the availability of suitable merger partners 

willing to absorb large numbers of insolvent institutions at 

favorable terms is Still unproven. S&Ls in the region of the 

country where most of the troubled thrifts are located are in 

significantly worse shape than those in the rest of the country. 

7 
To illustrate, the 479 thrifts in the Dallas Federal Home Loan 

Bank district, the district with the most insolvent thrifts, had 

negative net worth of $6.7 billion at December 31, 1987. 

Additionally, FSLIC assumes that investors will be willing to 

accept FSLIC notes, rather than cash, as an acceptable form of 

assistance. In view of FSLIC's precarious financial condition, we 

believe the degree to which FSLIC notes will be accepted as 

substitutes for cash remains an open question. 

We want to emphasize that simply merging two or more weak 

institutions into a larger one does not necessarily represent a 

problem resolution. For such a consolidation to offer promise of 

stability, the resulting entity must normally be well capitalized, 

which usually requires a substantial infusion of high quality 

assets. 

Lower Resolution Costs 

FSLIC also assumes that future resolutions will be less 

expensive than in the past and that resolutions will occur rapidly, 

minimizing additional losses to insolvent thrifts and FSLIC's 

costs, with virtually no new problem cases beyond those already 

identified. For the currently insolvent institutions not included 

in its $17.4 billion liability, FSLIC projects resolution costs 

equal to the institutions' negative tangible net worth--about 

$5.3 billion. However, based on experience, this estimate is 

optimistic. As previously discussed, using historical resolution 

costs as a percentage of assets to estimate the costs for these 

institutions indicates that resolution costs could reach 

$19 billion. 

FSLIC also forecasts incurring over $14 billion in resolution 

costs during fiscal years 1988 and 1989, and assumes that virtually 

no new resolutions will be required after fiscal year 1992. 

Neither 1987's performance (52 resolutions) nor resolutions 

accomplished thus far in 1988 (22 through April 1988) indicate that 

FSLIC can act on cases this rapidly. Moreover, FSLIC's assumption 

that no new problem cases will develop appears extremely optimistic 

in view of the industry's current condition and most recent 

operating results. In particular, if interest rates should 

significantly increase, S&Ls could be faced with the interest rate 

spread problems that occurred 10 years ago. 

Revenue Projections 

FSLIC's revenue projections are based on several relatively 

optimistic assumptions regarding interest rates and future 

conditions in the savings and loan industry and in the U.S. 

financial markets. The effects of these assumptions are 

interrelated-- should future conditions vary significantly, both 

FSLIC's projected revenues and outlays could be adversely affected. 

8 
-- Growth in Deposits at Insured Institutions - FSLIC assumes 

that insured deposits will grow about 7 percent annually, 

roughly doubling insured deposits over 10 years. Because 

FSLIC's premium income (both regular and special 

assessments) is based upon fixed percentages of insured 

deposits, its revenues increase significantly under this 

scenario. While this growth rate is consistent with the 

overall growth experienced over the past decade, we believe 

it may be overly optimistic. While deposits grew 

dramatically in 1983 and 1984, the growth rate declined in 

1985, 1986, and 1987. Moreover, CEBA imposed a moratorium 

on thrifts leaving the FSLIC system which expires in August 

1988--any significant departures of thrifts would result in 

corresponding decreases in deposit growth. This assumption 

further implies that other financial institutions are not 

able to take away any substantial portion of the thrift 

industry's current business. 

-- 

-- 

Special Assessment Income - FSLIC's forecast assumes FSLIC 

will continue the special assessment of l/8 of 1 percent of 

insured deposits throughout the next 10 years. However, 

under CEBA the special assessment was to be phased out by 

1991. Although CEBA contains provisions permitting the 

Bank Board to continue the special assessment under certain 

circumstances, the Bank Board has not officially indicated 

what it plans to do. Moreover, continuation of the special 

assessment could encourage healthy thrifts to transfer to 

the Federal Deposit Insurance Corporation, thus eroding the 

deposit base from which FSLIC's premium income is 

generated. Conversely, without continuing the special 

assessment, there is no shred of hope of resolving FSLIC's 

financial plight without turning to the taxpayer. 

Recapitalization Bonds and Related Interest Expenses - 

FSLIC's revenue forecast projects that recapitalization 

bonds will be marketed at interest rates of slightly less 

than 10 percent, which has been the case thus far. While 

FSLIC receives the proceeds from the bond sales, it must 

also bear the interest costs on the bonds. The interest 

costs will be paid from FSLIC's assessment income over the 

30-year life of the bonds. Thus, significant increases in 

overall interest rates would reduce FSLIC's funds. Such a 

reduction would be compounded if higher interest rates were 

accompanied by slower deposit growth than FSLIC 

anticipates. 

Other Sources of Funds 

In addition to funds from recapitalization proceeds, 

insurance premiums, investment income, and liquidating assets, 

FSLIC and the Bank Board have access to funds from other sources. 

9 
However, each of these sources has drawbacks, and most do not add 

to FSLIC's reserves because the money must be repaid.1 

-- 

-- 

-- 

-- 

Borrowing From the Treasury - FSLIC has a $750 million line 

of credit available if the Bank Board determines funds are 

needed for insurance purposes. 

Borrowing From the Federal Reserve System - FSLIC can 

borrow directly from the Federal Reserve System under two 

different authorities and indirectly under one other 

authority. The amount available under each authority 

depends upon the amount of suitable collateral at FSLIC's 

disposal. 

Borrowing From the Federal Home Loan Banks - FSLIC is 

authorized to borrow from the Bank system under certain 

limitations.2 In addition, if the Secretary of the 

Treasury and the Chairman of the Bank Board certify to the 

Congress that alternative means of raising funds cannot be 

used and the ability to supply such funds is impaired, the 

Treasury can purchase up to $4 billion of Federal Home Loan 

Bank obligations, which could then be used to assist the 

thrift industry. 

Mandatory Infusion of Up To 1 Percent of Withdrawable 

Deposits Into FSLIC - The Bank Board is authorized to 

require insured S&Ls to make such deposits into FSLIC. 

According to Bank Board officials, FSLIC could raise over 

$9 billion in this manner; however, its liabilities would 

increase by an equal amount. 

FSLIC has not included funds from these sources in its 

projection and we agree with that decision. In our view, these 

sources are accompanied by serious disadvantages, and their use 

should only be considered in an extreme emergency. 

GAO'S VIEW ON FSLIC'S ABILITY 

TO DEAL WITH THE INDUSTRY'S PROBLEMS 

As previously discussed, we view FSLIC's projections with 

significant reservations. It is understandable that FSLIC faces 

its challenges with a high degree of optimism. While we believe 

FSLIC's projections and their underlying assumptions are relatively 

1For more detailed information on these sources of funds, see 

Thrift Industry: The Treasury/Federal Home Loan Bank Board Plan 

for FSLIC Recapitalization (GAO/GGD-87-46BR, March 3, 1987). 

2FSLIC has used this authority twice to fund pass-through loans to 

insured institutions. 

10 
optimistic, we do not question either the sincerity or the ability 

of those who developed them. Nonetheless, depending upon the 

outcome of the various uncertainties underlying FSLIC's 

projections, we conclude that the eventual costs of restoring the 

thrift industry's financial health are likely to exceed the funds 

that FSLIC will have available. In addition, because of the 

distressed financial condition of a large segment of the industry, 

it also appears unlikely that the industry would have the resources 

to provide such funding. Consequently, further congressional 

action may well be needed to obtain adequate funding. 

However, as we said earlier, FSLIC does have sufficient 

resources to continue operating and resolve cases in the near term. 

FSLIC has established an ambitious plan for rapidly resolving 

cases. Whether or not FSLIC can effectively accomplish this plan 

should become readily apparent in the near future. 

In closing, we would like to emphasize our view that if 

congressional action becomes necessary, it should be taken 

swiftly. Any delays in acting on insolvent thrifts inevitably 

result in increased resolution costs and undermine the stability of 

all financial institutions. Such has been the bitter lesson of the 

current thrift industry crisis. 

Mr. Chairman, this concludes my formal statement. At this 

time, I would be pleased to answer any questions you may have. 

11 
ATTACHMENT I A'ITACHMENT I 

GAAP Net Nunber Percent lbtal Total 

Wrth ($1 of SE&s of mtal Assets Deposits 

Less than -12% 

From -12 to -9% 

From -9 to -6% 

From -6 to -3% 

From -3 to 0% 

From 0 to 3% 

From 3 to 6% 

From 6 to 9% 

From 9 to 12% 

kre than 12% 

mtal 

182 5.8 

33 1.1 

61 1.9 

75 2.4 

154 

435 

4.9 

13.8 

1,014 

743 

32.2 

23.6 

290 9.2 

160 5.1 

3,147 1oo.o 

$ 43.2 $ 49.3 

5.5 4.7 

23.0 19.6 

17.5 14.8 

51.1 40.4 

255.2 175.7 

555.9 398.7 

231.0 177.1 

38.6 31.6 

30.7 20.9 

$1.251.7 a&u 

SELECTED FINANCIAL INFORMATION FOR 

SAVINGS AND IDAN INSTITUI'IONS 

AS OF DECEMBER 31, 1987 

($ in billions) 

Net Wrth 

$(14.2) 

(0.6) 

(1.7) 

(0.7) 

(0.7) 

4.0 

25.0 

15.9 

3.9 

6.0 

$169 

12 
ATI'ACHMENT II A'ITACHMENT II 

SELECTEDFINANCIAL INFORMATIONFOR 

SAVINGS AND IQAN INSTI'IWI'IONS IN THE 

DAIUG E’EDERAL, HDME IOAN BANK DISTRICT 

AS OF DECJMBER 31, 1987 

($ in billions) 

GAAP Net 

Worth (%I 

Nunber Percent TWal Total 1987 Net GAAP 

of S&Is of Twal Assets Deposits Income Net vbrth 

Less than 0 % 181 37.8 $ 59.4 $ 57.1 $(6.51) $(10.16) 

From 0 to 3% 91 19.0 35.4 26.1 (0.44) 0.59 

From 3 to 6% 118 24.6 25.7 19.6 (0.12) 1.12 

kre than 6% 89 18.6 13.2 9.9 0.04 1.79 

Total 479 100.0 uu $112.7 S(7.032. S(6.66) - 

13 
ATTACHMENT III ATTACHMENT III 

TO BE DELIVERED 

B-114893 

To the Chairman 

Federal Home Loan Bank Board 

We have examined the consolidated statements of financial 

condition of the Federal Savings and Loan Insurance 

Corporation as of December 31, 1987 and 1986, and the 

related consolidated statements of income and expense and 

reserves, and changes in financial position for the years 

then ended. Our examinations were made in accordance with 

generally accepted government auditing standards and, 

accordingly, included such tests of the accounting records 

and such other auditing procedures as we considered 

necessary in the circumstances. In addition to this report 

on our examination of the Corporation's 1987 and 1986 

consolidated financial statements, we are also reporting on 

our study and evaluation of internal accounting controls 

and compliance with laws and regulations. 

SAVINGS AND LOAN INDUSTRY'S 

FINANCIAL CONDITION 

Over the past decade, the savings and loan industry has 

experienced severe financial difficulties. During this 

time, as restrictions on deposit rates were progressively 

14 
ATTACHMENT III ATTACHMENT III 

B-114893 

lifted and competition for deposits escalated, savings and 

loan associations had to pay increasingly higher interest 

rates to preserve their core deposits at the same time they 

were encumbered with low-yielding loan portfolios. The 

resulting negative interest rate spread led to large 

industry-wide operating losses and capital depletion in 

1981 and 1982. With the liberalization in the early-1980s 

of the types of activities in which thrifts could 

participate, many institutions began to diversify their 

asset portfolios away from traditional home mortgage loans 

and into other activities. These activities included 

transactions such as acquisition, development, and 

construction loans, and various direct investments, which 

offer potentially higher rates of return, but carry 

commensurate risk. Moreover, the profitability of many of 

these activities was predicated upon continued increases in 

real estate values to make them economically viable. 

Although interest rates declined sharply beginning in late 

1982, reducing or eliminating the negative interest rate 

spread problem, many institutions have been adversely 

affected by substantial losses on their loans and 

investments. These losses have been further compounded by 

15 
ATTACHMENT III ATTACHMENT III 

B-114893 

the severe economic downturn in the Southwest. Between the 

end of 1982 and 1986, the number of insolvent thrifts as 

measured by generally accepted accounting principles more 

than doubled from about 220 to 460. 

In 1987, the industry's financial condition continued to 

deteriorate. The 3,147 FSLIC-insured savings and loan 

institutions reported an overall net loss of $6.8 billion. 

Although nearly two-thirds of these institutions operated 

profitably, earning $6.6 billion during the year, those 

profits were far outweighed by the $13.4 billion in losses 

incurred by the remaining one-third of the institutions, 

located primarily in the Southwest. In 1987, the number of 

insolvent institutions further increased to 505, with 

reported negative net worth of $18 billion. 

THE CORPORATION'S 

FINANCIAL CONDITION 

The deterioration of the industry's financial condition has 

overwhelmed the resources the Corporation had accumulated 

to protect depositors. At the end of 1980, the Corporation 

had reserves of $6.5 billion, representing 1.35 percent of 

16 
ATTACHMENT III 

B-114893 

ATTACHMENT III 

total insured deposits: at December 31, 1987, it had a 

deficit of $13.7 billion. Due to increasing costs related 

to insurance actions, the Corporation began incurring 

losses in 1984. The Corporation's 1987 loss of 

$8.6 billion was primarily due to the $3.5 billion in costs 

related to institutions that have closed or received 

assistance and to the $6.9 billion increase in its 

liability for failed but still operating institutions. 

The accompanying financial statements reflect a 

$17.4 billion liability for the expected costs of resolving 

the problems of the more than 200 hopelessly insolvent 

institutions for which the Corporation had assumed 

responsibility as of December 31, 1987, as well as several 

other institutions whose problems the Corporation expects 

to resolve in 1988. Because of the thrift industry's 

continuing difficulties, the Corporation has had to accept 

responsibility for increasing numbers of savings and loan 

institutions needing financial assistance. At the same 

time, its own weakened financial condition has prevented it 

from taking prompt action to liquidate or assist troubled 

institutions. As a result, a significant number of the 

failed but still operating institutions that were in the 

17 
ATTACHMENT III ATTACHMENT I II 

B-114893 

Corporation's 1986 caseload were still in its 1987 

caseload. In 1986, the Corporation's caseload increased 

from 93 institutions to 183. During 1987, its caseload 

further increased to 205. These 205 institutions reported 

total assets of $52.1 billion and negative tangible net 

worth of $14.6 billion at the end of 1987. In contrast, 

the 183 institutions in the Corporation's 1986 caseload 

reported total assets of $55.1 billion and negative 

tangible net worth of $8.2 billion. 

The $17.4 billion liability at December 31, 1987, is not a 

projection of the cost to resolve all known problems in the 

industry. Instead, as previously noted, it is primarily 

the estimated cost to resolve the problems of those 

insolvent institutions for which the Corporation had 

assumed responsibility. At December 31, 1987, almost 300 

additional institutions with assets of about $88 billion 

were insolvent using generally accepted accounting 

principles, exposing the Corporation to further risk. 

A precise estimate of the eventual cost to resolve the 

problems of the 300 additional institutions cannot 

presently be made beCaUSe the cost depends upon various 

18 
ATTACHMENT III ATTACHMENT III 

B-114893 

uncertainties, such as the quality of each institution's 

assets, future interest rates, and the economic outlook for 

certain sectors of the economy in which many of the 

troubled institutions operate. The Corporation believes 

that the negative tangible net worth of those institutions 

indicates that the cost to resolve the problems of the 

additional 300 institutions will be at least $5.3 billion. 

We believe that this estimate may substantially understate 

the magnitude of financial assistance the institutions will 

need. 

We expect these institutions, which have been incurring 

losses and which the Corporation probably will not act on 

for several years, to incur future operating losses, thus 

increasing the eventual costs the Corporation must absorb. 

In addition, the historical costs of resolving 

institutions' problems have consistently exceeded the 

reported negative tangible net worth of those 

institutions. Over the last 3 years, liquidating and 

merging institutions cost the Corporation more than 

20 percent of an institution's assets and generally 

exceeded negative tangible net worth by almost 70 percent. 

Our estimates of the Corporation's ultimate cost to deal 

19 
ATTACHMENT III ATTACHMENT III 

B-114893 

with these additional institutions, using historical 

factors, would indicate that the potential cost for the 300 

additional institutions could be substantially in excess of 

the currently reported $5.3 billion negative tangible net 

worth, and range from $9 to $19 billion. 

OUTLOOK FOR THE CORPORATION 

Our opinion on the Corporation's 1986 financial statements, 

dated May 1, 1987, was qualified as subject to the 

Corporation "obtaining sufficient funds to continue 

operating and to meet its obligations." On 

August 10, 1987, the Congress passed the Competitive 

Equality Banking Act of 1987 which provides for 

recapitalizing the Corporation through the sale of a 

maximum of $10.8 billion in bonds over a 3 to 10 year 

period. The bonds will be repaid by the proceeds from zero 

coupon securities purchased with Federal Home Loan Bank 

funds, while the interest will be paid using a substantial 

portion of the next 30 years' insurance premiums the 

Corporation would otherwise receive. 

20 
ATTACHMENT III ATTACHMENT III 

B-114893 

Over the next 10 years, the Corporation expects to have 

about $28 billion in net new funds from regular 

assessments, special assessments, and the sale of bonds 

authorized by the Competitive Equality Banking Act of 

1987, as well as the sale of assets from existing 

receiverships available for resolutions. Although this 

amount covers the current estimated cost related to the 

Corporation's 1987 caseload, depending upon the outcome of 

various uncertainties, it probably will not be adequate to 

resolve the problems of the additional 300 troubled 

institutions or to address any future problems in the 

industry. 

In estimating its funds available for resolution, the 

Corporation has assumed that: 

-- The amount of FSLIC-insured deposits will grow by more 

than 7 percent each year. While this assumption is 

consistent with overall growth during the last 10 years, 

it exceeds the growth rate over the last 3 years. 

Further, this assumption implies that no significant 

number of institutions will leave the FSLIC system in 

spite of the planned expiration in August 1988 of the 

21 
ATTACHMENT III 

B-114893 

ATTACHMENT III 

moratorium on exits from the system. This assumption 

further implies that other financial institutions are 

not able to take away any substantial portion of the 

thrift industry's current business. 

em It will continue the special assessment of l/8 of 

1 percent of insured deposits throughout the next 

10 years. 

-- Recapitalization bonds will continue to be marketed at 

interest rates of slightly less than 10 percent. 

We believe that these assumptions are relatively optimistic 

and, as with any projection, may prove incorrect. An 

adverse change in any of these assumptions will reduce the 

Corporation's available funds and affect its ability to 

resolve the industry's problems. 

In determining the costs related to its caseload, the 

Corporation has assumed that: 

-- It can minimize its resolution costs by selling or 

merging substantially all institutions rather than 

22 
ATTACHMENT III 

B-114893 

ATTACHMENT III 

-- 

liquidating them since liquidations are almost 

invariably more expensive than mergers. However, over 

the last 5 years, more than one-third of the 

Corporation's resolutions were liquidations. 

It can act on most of the problem institutions in the 

next 2 years, thus, minimizing those institutions' 

additional losses and the cost to the Corporation. 

Since assistance agreements usually contain provisions 

requiring the Corporation to, as a minimum, compensate 

the acquirer for the negative net worth of the troubled 

institutions, allowing institutions to continue 

operating and incur additional losses would increase the 

Corporation's resolution costs. 

we Interest rates will remain favorable and will not 

increase to any significant extent. Any significant 

increase in costs of funds to the thrift industry could 

again exacerbate the financial pressures on the industry 

and cause additional deterioration in capital and 

profitability. 

23 
ATTACHMENT III ATTACHMENT III 

B-114893 

-- Virtually no new problem cases will develop in the 

industry over the next 10 years and no further 

resolution costs will be incurred beyond those currently 

identified. 

Finally, while it was initially contemplated, both in 

originally establishing the Corporation and in 

recapitalizing it in 1987, that the industry would be able 

to provide the funds needed to resolve its problems, the 

deteriorated capital position and poor operating results 

of a large segment of the industry seriously impair the 

industry's ability to do so. In this regard, the 

deterioration has continued up to the present--in the first 

quarter of 1988, the industry reported further capital 

losses of $3.3 billion. 

GAO OPINION 

As a result of the above conditions, namely, 

-- the magnitude of the resolution costs for currently 

insolvent institutions, 

24 
ATTACHMENT III 

B-114893 

ATTACHMENT III 

-- the uncertainties about the Corporation's future revenue 

streams, 

-- the Corporation's current $13.7 billion deficit, and 

-- the industry's deteriorated financial condition, 

we believe that further congressional action, beyond that 

already taken under the Competitive Equality Banking Act of 

1987 to recapitalize the Corporation, may well be needed to 

enable the Corporation to continue to meet its obligations 

and provide the deposit insurance it is mandated to 

provide. 

In our opinion, subject to the potential need for further 

congressional action to enable the Corporation to resolve 

the industry's problems and meet its obligations, the 

financial statements referred to above present fairly the 

financial position of the Federal Savings and Loan 

Insurance Corporation as of December 31, 1987 and 1986, and 

the results of its operations and changes in financial 

25 
ATTACHMENT III ATTACHMENT III 

B-114893 

position for the years then ended, in conformity with 

generally accepted accounting principles applied on a 

consistent basis. 

26 
ATTACHMENT IVAlTACHMENT IV 

FEDERAL SAVINGS ANTI IOAN INSURANCE CORFQRATION 

SUMMARY CONSOLIDATED STATEMEMI' OF FINANCIAL CONDITION 

ASSETS 1987 

Cash ard investments $ 3,400,000,000 

Claims against assets of closed institutions (net) 4,900,000,000 

limns and assistance to insured institutions 2,200,000,000 

l?oTAL Assm $ 10,500,000,000 

LIABILITIES 

Accounts payable ard other liabilities $ 100,000,000 

Notes and interest payable to insured institutions 5,100,000,000 

Notes payable to Federal HOme I&an Banks 900,000,000 

Estimated losses under existiq agreements with 

acquirers 

Liability for losses 

TOTAL LIABILITIES 

700,000,000 

on unresolved cases 

(DEFICIT) 

17,400,000,000 

24,200,000,000 

INSmAN~EutmRE!SEXvE 

Fkcapitalization funds 

Primary reserve 

mm RESERVE (DEFICIT) 

1,200,000,000 

(14,900,000,000) 

$(13,700,000,0001 

1986 

$ 4,100,000,000 

3,800,000,000 

3,000,000,000 

$ 10,900,000,000 

$ -O5,000,000,000 

900,000,000 

800,000,000 

10,500,000,000 

17,200,000,000 

$( 6,300;~00,0001 

$( 6,300,000,0001 

27 
ATTACHMENT IVATTACHMENT IV

FEDERAL SAVINGS AND ILlAN INSURANCE CORFORATION 

SUMMARYCONSOLIDA~D STATEMENT OF INCOME AND l%F'EiNSES 

INCOME 1987 1986 

Insurance premiuns 

Special assessment premiuns 

Interest income 

Otherincane 

$ 700,000,000 

1,100,000,000 

400,000,000 

200,000,000 

$ 700,000,000 

1,100,000,000 

500,000,000 

100,000,000 

VYr~INCotw 2,400,000,000 2,400,000,000 

EXPENSES 

Administrative and related expenses 

Interest expense 

300,000,000 

300,000,000 

100,000,000 

300,000,000 

Provision for losses related to claims against 

assets of closed institutions 

Provision for losses related to acquisitions 

and mergers 

Provision for losses related to unresolved cases 

TurAL ExPEiNsEs 

NEI'UXSFROt4OPERATIoNs 

1,800,000,000 2,900,000,000 

1,700,000,000 1,100,000,000 

6,900,000,000 8,900,000,000 

11,000,000,000 13,300,000,000 

$( 8,600,000,000) $(10.900,000.009) 

28