September 13, 1991

Hearing Before
 Subcommittee on Telecommunications and Finance
Committee on Energy and Commerce
102nd Congress

on
A bill to Amend the Federal Securities Laws to Equalize the Regulatory Treatment of Participants in the Securities Industry



WRITTEN TESTIMONY OF: STEPHEN P. PIZZO AND MARY FRICKER

Co-Authors, INSIDE JOB: The Looting of America's Savings and Loans

Distinguished members of the committee:

Keeping bank deregulation from becoming a replay of thrift deregulation and the carnage that followed is one of the most serious challenges facing this Congress. Echoing, almost to a word, the pleas of thrift industry lobbyists 10 years ago, bankers and their lobbyists are pushing Congress hard for bank deregulation:

In 1981 savings and loans were clamoring for deregulation because, they said, they couldn't make a profit making home loans. They needed to be able to diversify, to get into ventures that

offered the promise of a higher return. Competition from money market funds, they said, was killing them. (Note: Many healthy S&Ls opposed that deregulation.)

Now, almost exactly a decade later the nation's big banks are clamoring for their own deregulation because, they too claim, they can't make a profit making commercial and consumer loans. They say they need to diversify, to get into ventures that offer the promise of higher returns. Competition from investment banks, financial conglomerates and international banks, they say, is killing them. (Note: Many independent community banks are opposing this deregulation.)

Commercial Banking vs. Investment Banking:

High on bankers' list of wants is the dismantling of the Glass- Steagall Act, which was passed in 1933 because many of the bank failures following the market crash in 1929 were caused by risky transactions conducted between banks and their securities affiliates. The Glass-Steagall Act removed banks from Wall street and, to entice a gun shy public back to banks, it created federal deposit insurance. (Bankers today want only one of these Glass-Steagall provisions retained .These would-be speculators still want deposit insurance. Free enterprise and level playing fields is one thing, but removing their federally-backed insurance safety net is quite another.)

If Congress again opens up banking to Wall Street speculation, as it opened up S&Ls and banks to real estate speculation, regulators will quickly lose control over the complex series of events that a pervasive marketplace will immediately set in motion. Insider abuse, self-dealing, and back scratching relationships between institutions will run rampant.

While speculators play an important role in a free market economy, their instincts and perspectives are exactly the opposite of those we want in our bankers. Wall Street investment bankers are to commercial bankers what fighter pilots are to airline pilots. One takes risks, the other avoids them. Investment bankers put their investors' money at total risk. On this high wire, there is no collateral and no federal insurance net below. An unlucky investor can take a plunge - not only to the floor but right through it, in some cases losing far more than just the money he invested. This is the world that commercial bankers want to re-enter.

And the Bush administration wants to accommodate this wish, hoping the repeal of the Glass-Steagall Act will attract new money to the banking industry, so the government won't have to recapitalize failing banks itself. Treasury Secretary Nicholas Brady is almost giddy over the prospect of merging banks and Wall Street. It makes sense, he says, because investment banking shares a "natural synergy" with commercial banking.

Sound familiar? The same argument was used a decade ago when savings and loans wanted to get into the construction and development business. Developers needed loans - thrifts made loans. Bingo. Natural synergy. Regulations prohibiting such joint ventures were abolished, and sure enough private capital poured into the thrift industry as developers bought thrifts and thrifts acquired their own construction companies.

"My God! This is what I've been waiting for all my life!" gasped the owner of (now defunct) San Marino Savings and Loan.

Almost immediately the predictable happened. The historical arms-length relationship that had existed between lender and borrower vanished, and with it went due diligence, common sense and, in too many cases, ethics. Thanks to facilitating that bit of synergy the taxpayer is stuck with $300 billion dollars worth of repossessed real estate from failed thrifts. If we sold $1 million worth of this stuff a day, it would take 3OO years to sell it all.

Deregulated banks can look forward to a similar script, with some of the same bad actors. U.S. Attorney Joe Cage in Shreveport,Louisiana, told us, "Some of the same people who took down savings and loans, are out in the securities business and banking now, already in place. And they're just waiting for Congress to abolish the Glass-Steagall Act. If that happens I'm afraid they'll take the banks just like they did the savings and loans."

Bankers want a piece of the insurance business as well. This idea was also tried by the S&Ls and proved just another way to loot the system. Many of the old S&L crowd - Gene Phillips, Charles Keating, Jr., Herman Beebe, Mike Milken - also had their hooks in insurance companies that have since failed: Pacific Standard Life, Executive Life, AMI Life, and a daisy chain of Texas insurance companies, to mention a few. An associate of a major S&L defaulter testified in court recently... "Wayne told me -that the S&Ls were tapped out and that we should find a new source for money. He told me we should consider getting into the insurance business."

Treasury wants corporate America to be able to own these banking securities-insurance conglomerates. But the benefits of corporate ownership and securities and insurance underwriting, would accrue primarily to (1) major companies that would like to have a bank (with its federally insured deposits) in their stables and to (2) bankers who have proven themselves so inept that they must have a huge infusion of private capital - from a new corporate owner - or a chance to "double down" on Wall Street in a desperate attempt to win big. A new breed of banker will use deposits to inflate the value of stock, extortion to sell insurance and investor's capital to benefit the bank or the bank's corporate ownership. Forget for a moment what bankers say they need and instead ask yourself if their customers, and your voters - taxpayers - need any of this;'

The big "money center" bankers argue that without deregulation American banks will not be able to compete with European banks after 1992, when the European Common Market will combine in a universal banking system with broad banking and securities powers. They also complain that they can't compete with the Japanese banks that are flooding U. S. markets. They pointedly note that no Am~rican bank ranks among the world's 10 largest banks.

So what? While European and Japanese banks appear more fragile every day, American regional and community banks grow stronger. Could that be why Japanese banks - widely believed to be under severe stress in spite of their happy-talk annual reports - are tapping into our regional markets? Why should Congress move in the direction of weakness instead of strength? If American mega-banks want to compete without restriction in the international arena, fine. Deregulate them, wish them well, withdraw their deposit insurance and let them have at it.

These bankers say they want a level playing field, so give it to them .. we  halt the 50-year-old tradition of exempting foreign deposits from deposit insurance premiums. It's interesting that, though bankers are complaining about all the so-called "outdated" regulations which are impairing their profitability, they have somehow forgotten this particular one. How convenient this "outdated" regulation is for a bank like Bankers Trust - recently approved for securities underwriting by the Federal Reserve Board -
which has about twice as many foreign as domestic deposits.

Many smaller banks, primarily represented by the Independent Bankers Association of America, are bitterly fighting the big banks' deregulation agenda - and their reward for sounding the alarm is that they are seen on Capitol Hill as "whiners." Interesting. The healthy regional banks are whiners and the nearly insolvent tumor-like, mega-banks - bearing about them a legion of past mistakes like the chains around Ebenezzer' s dead business partner's ghost - are welcomed by Congress with open ears. It's most curious, and if this legislation passes, and results in another disaster, voters will want to know why.

Some banks sorry that other industries are encroaching on traditional banking services. American Express, for example, offers through its subsidiaries: depository services, real estate services, securities, credit cards, mutual funds, financial planning, investment banking, merchant banking, international banking, international currency transactions, insurance and data processing. What they do not offer are insured deposits and community lending.

vIe favor letting banks become financial service centers in their communities -selling insurance, stocks, bonds and mutual funds, offering financial planning services and in general meeting the financial needs of their customers. But, to do this, banks do not need the inevitable conflicts of interest inherent in corporate ownership or the enormous risks inherent in securities and insurance underwriting. What advantages occur to the American public by allowing banks into these fields? None-- 0

Firewalls

Bankers assure their critics that the potential dangers of corporate ownership and securities and insurance underwriting are moot issues because bankers will agree to impenetrable firewalls between their corporate, banking, securities and insurance affiliates. If the securities company gets into trouble, for example, firewalls will protect the bank's federally insured deposits - they claim.  Apparently, through some magical osmosis that only works one way, Americans are asked to believe that banks will enjoy the benefits of having securities affiliates without ever being affected by their problems.

But even as pro-deregulation forces pay lip service to firewalls, they attack them. Federal Reserve Board chairman Alan Greenspan, v,ho has been leading the charge toward bank deregulation evidently undaunted by his doomed infatuation back in 1985 with S&L deregulation and Charles Keating, Jr. - cut to the heart of the firewalls matter when he admitted that firewalls "undercut the reason for granting any additional powers to banking organizations in the first place."

And this time Greenspan might just be right. Firewalls proved quite unreliable during the S&L debacle. In the 1980s, when a thrift's risky investments started going sour, regUlatory firewalls were easily breached. For example, thrift executives were forbidden by regUlations from making loans to themselves, their families, business associates or interests - a firewall. To get around this firewall, thrift management simply found like-minded management at other thrifts and each made loans to one another. So much for fire walls.

Our expensive S&L lessons should have taught Congress that if banks are allowed back into the securities business something like this would almost certainly occur the next time Wall Street crashes:

A bank's securities clients would suddenly be strapped for hundreds of millions of dollars to cover margin calls as programmed trading plunged the market to new depths.

- The bank's securities affiliate itself would be trying to support stocks it had underwritten and would need a big cash infusion fast.

So what do we have? We have a group of frantic, cash-starved players who own a bank but can't use its cash to bail themselves out of trouble. In this scenario it wouldn't take these desperate bankers long to figure out that a like-minded - and similarly strapped - bank holding company was just a phone call away. They eQuId quickly arrange millions in loans to each other and to each other's clients just like thrift officers did. In the flash of a wire transfer and a programmed trade, hundreds of millions of dollars, maybe billions, would go right down another federally-insured rat hole. They'd worry about dealing with irate regulators later.

Though these scenarios are simplified versions of what would no doubt be almost incomprehensibly complex transactions - to hide them from regulators - the fundamental point is this: A business in deep trouble, seeing a chance to make a killing, will use all the assets at its disposal (particularly those belonging to someone else), even federally insured ones, and will worry about the consequences later.

Banking consultant David Silver has studied the question of firewalls and has concluded, "History indicates that, while firewalls work in normal times, even strong firewalls are inadequate when they are needed most -- in times of fire."

Walter Wriston, former chairman of Citicorp, candidly admitted the futility of firewalls when he said, "Lawyers can say you have separation, but the marketplace is persuasive and it would not see it that way."

An historical look at one bank, Continental Illinois Bank & Trust Co. of Chicago, says reams about bank deregulation. In 1933 it was the first major bank in the country to be bailed out by the federal government as a result of the Great Depression. In 1984 the federal government bailed it out again, to the tune of $4.5 billion. Both times, according to FDIC chairman Irvine Sprague, the problems were the same:

"Concentration of assets, out-of-territory lending, pursuit of growth at any cost encourage institutions to go for the fast buck; a bigger bank means more compensation for its management." Prior to the second bailout, Continental had hooked up with the flim-flam crowd at Penn Square Bank in Oklahoma City, where wild speculation, insider abuse and fraud sucked the life from both Penn Square and Continental.

Did those two lessons teach Continental anything about prudence and risk? Apparently not. In 1987 when the stock market crashed Continental (still owned primarily by the federal government) was caught with its options down - which gave Continental an opportunity to show Americans how firewalls don't work. It made an emergency $385 million loan to its options trading subsidiary in spite of a firewall (regulation) that prohibited such a transaction. Reportedly, the bank was never censured by regulators because they agreed the loan was critical to Continental's survival - but they did require that Continental route the money to its holding company, to avoid a direct violation of the regulation against a bank making a loan to its own securities affiliate.

None of these concerns has deterred the Bush Administration and many on Capitol Hill from supporting a two-tiered hOlding company structure that is so ludicrous it must be a parody on bank deregulation. In these two-tiered New World conglomerates, commercial and industrial companies would own a Diversified Holding Company that would own a string of companies (engaged in real estate, insurance and various commercial enterprises). The Diversified Holding Company would also own a Financial Services Holding Company that would own a bank, a securities affiliate and other subsidiaries.

The Financial Services Holding Company and its subsidiaries would be "absolutely prohibited" from lending "upstream" to its parent Diversified Holding Company and subsidiaries, yet according to one
summary the structure "would permit non-banking firms to invest their significant resources in the capital deficient banking industry. " Why, one might ask, would they want to do that, if they can't use the bank's money? Maybe as a selfless act of public service?

How examiners might detect lending within that maze has not been explained. There's not a bank examiner in this country who could control such a corporate banking octopus. If S&L regulators couldn't stop the looting at savings and loans - which are by comparison a fairly straight forward corporate structure - what hope is there that bank regulators will be able to monitor a two-tiered holding company structure with multiple affiliates and subsidiaries?

In fact, bankings high flyers will be encouraged in their deceptions by an examination system that - according to George Champion, retired chairman of Chase Manhattan Bank, and Paul Craig Roberts, a former assistant secretary of the Treasury, writing in 1989 - is incompetent, rife with conflict of interest and has broken down. The General Accounting Office said in March that in 37 out of the 72 cases it studied, regulators weren't aggressive enough in dealing with troublesome banks. In candid moments bankers themselves will tell you that lax accounting guidelines permit troubled banks to distort the truth and hide their problems until another day.

It is this antiquated and inadequate system Congress that is about to ask to monitor banks involved in securities and insurance underwriting. Regulators will have to unravel the dealings of complex bank holding company structures, foreign transactions, national and international activities, sophisticated hedges and straddles and options and swaps, and thousands of daily electronic transfers among affiliates and subsidiaries and brokers.

At the same time the current legislation pays only lip service to a strong regulatory structure. It does not outline how the regulatory structure will be beefed up, or where the money will come from to attract the thousands of additional first-rate examiners that will be needed. If specific provisions for funding this examination force are not included in any bank deregulation legislation, the legislation should be dropped like a hot potato. If Congress tries to enact it later, the same bankers who are now purring like kittens, to get what they want, will become tigers who will attack any plan that increases their deposit insurance premiums or asks them to contribute to the regUlatory kitty.

Interstate Branching

Bankers pleas for interstate branching should also be ignored. It isn't needed - banks can already loan everYWhere and draw deposits from everywhere (and both powers have been a major source of problems for banks). Allm,ing them to have branches everY\'lhere will only encourage the creation of more mega-banks as the tumor-banks gobble up, PackMan style, heal thy community banks across the country to feed their lust for a nationwide branching structure.

The net result of interstate branching will be fewer banks and the consolidation of the industry into a group of mega-banks, each of which will then be perceived by regulators as being decidedly Too Big To Fail. Instead of a small percentage of the industry falling into that questionable category, nearly the entire industry will fall on the taxpayer's shoulders.

Another unpleasant fallout of interstate banking will be increased unemployment. The reason is simple. Small business supplies and creates the majority of jobs in America, not the big corporations which, in fact, move jobs offshore.

Once America's community banking structure has been absorbed by the big banks, which in turn have been absorbed by Fortune 500 corporations, the commercial lending patterns which made America the world capital of small business and entrepreneurship will change course. Banks steeped in the corporate culture will not understand the needs of small business and will prefer channeling their loans into more familiar corporate ventures. Slowly small business will be choked off as operating loans, inventory loans and start-up capital dry up. In the end Congress will be faced with only one alternative - a massive government loan guarantee program for small business finance - a government program which, we can all rest assured, will be mismanaged and very expensive.

Banks' demands for dramatic changes come at a time when banks are weaker than they have been since the Great Depression. Almost 1,000 banks have failed in the last four years, more than failed in the first 50 years after Glass-Steagall was passed. Restrictive regulations did not cause these problems, as the big banks would have Congress believe. Instead, in the last five years American bankers have discovered about $75 billion in bad loans on their books. vii th judgment that faulty, it's terrifying to think what they could have done on Wall street. Never ones to be contrite about losing other people's money, however, the bankers explain that in essence the devil made them do it. They say that it was those "old-fashioned federal regulations" barring banks from other, potentially greener pastures that forced them into those bad deals.

others disagree. Irvine Sprague, FDIC chairman until 1986, said most bank failures are caused by one thing - greed. The Comptroller of the Currency said bad management is to blame. The General Accounting Office found insider abuse at 64 percent of the bank failures it studied. The FDIC reported that criminal misconduct by insiders was a major contributing factor in 45 percent of recent bank failures.

Swindlers have always been attracted to banks because, as legendary bank robber Willie Sutton explained, "that's where the money is." During our eight-year study of savings and loans, the biggest S&L rogues we identified had cut their teeth by looting banks first. An FBI agent in Texas told us, "The only difference (between banks and thrifts in Texas) is that the FDIC still has its head in the sand on banks. When I looked at the banks that closed between 1984 and 1987, in many of them I found people I knew, the same S&L crowd I'm investigating from the failed thrifts there."

High flyers like these make it a point to know where the money is and to get at it before regulators know its gone. And they stand today straining at the starting gate, with their eyes on Congress and the banks. A man who arranges mezzanine financing for leveraged buyouts told us not long ago, "I think I'll go buy a bank. They only cost $3 million." When an LBO player thinks a stodgy old bank is suddenly attractive, should Congress begin to worry?

As for bankers who find themselves locked in this fatal attraction, they should turn for advice to some of their former cousins who pushed so hard for savings and loan deregulation. These former thrift operators might tell bankers to be careful what they ask for - they might just get it.

What should Congress do?

The lesson of the S&L crisis is that deregulation of the financial services industry should be treated like brain surgery - a little bit goes a long way. Cut away too much and the patient you were trying to help will wake up acting in strange and self destructive ways.

Some banks are sick and they need congressional medicine. But not the narcotics they are begging for. What they need is:

Risk-based deposit premiums, and:

But the bottom line is really this: Most banks are healthy. They know what they're doing. Leave them alone. Don't be spooked into a big 'operation when some delicate surgery will do.

It would be nice to think that Congress will apply the lessons of S&L deregulation to bank deregulation, but the record says Congress doesn't learn from history. Ferdinand Pecora's "Wall Street Under Oath," for example, which is the story of congressional hearings held in 1933 and 1934 on the collapse of Wall Street and the banking industry, reads as though it were written today. Even the players are the same: J.P. Morgan and Company, Chase National Bank, Bankers Trust Company, Dillon, Read and Company, Drexel and Company, Lehman Brothers, Kuhn Loeb and Company (Lehman and Kuhn Loeb are now part of Sherson/Lehman).

More recently, in 1976 the House Banking Committee held hearings in Texas to investigate bank failures, and the chairman of the committee, Fernand st Germain, said at those hearings, "We have been repeatedly told that most major bank failures have been caused by criminal conduct."

Committee member Henry Gonzalez said, "Inadequate regulation is what has made possible the kind of outlandish sordid conduct we have discovered."

Yet six years later st Germain sponsored the Garn-St Germain legislation to deregulation savings and loans, as though his hearings in Texas had never taken place. (Gonzalez voted against it.) Thus unleashed, S&Ls during the unregulated 1980s united with securi ties firms and insurance companies, and the results were thoroughly predictable. Drexel Burnham Lambert, Lehman Brothers, Lincoln Savings, Columbia savings, San Jacinto Savings, Pacific Standard Life Insurance, Executive Life Insurance, AMI Insurance, Vernon Savings - for a brief moment in time they enjoyed a deregulated relationship. Now they no longer exist.

Is that what Americans want for their banks?

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In addition to the attached material, we refer readers of this congressional record to two important books: "Bailout" by Irvine Sprague (FDIC chairman until 1986), published by Basic Books, Inc., in 1986, and "Wall Street Under Oath" by Ferdinand Pecora (Counsel to the United States Senate Committee on Banking and Currency, 1933-1934), published by Augustus M. Kelley in 1939 and reprinted in 1968. Because both books are out of print and may be difficult to acquire, we are attaching important passages:

From Irvine Sprague in "Bailout:"

"The list of super banks is sure to grow as interstate banking, an inevitable fact of the future, will just as inevitably produce combinations that will dwarf the present giants of the industry ... Major banks will continue to be treated differently than small ones. I cannot believe that any future FDIC board would allow the collapse of one of the giants of American banking."

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"The major banks of the nation today range virtually unchecked throughout the world, gathering deposits, lending money with abandon, and piling up off-book liabilities - some risky and few capitalized. "

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"The record of repeat behavior points to the greed factor that remains the major - often the only - reason for a bank's failure. Banks fail in the vast majority of cases because their managements seek growth at all cost, reach for profits without due regard to risk, give privileged treatment to insiders, or gamble on the future course of interest rates. Some simply have dishonest management that loots the bank."

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From Ferdinand Pecora in "Wall Street Under Oath" (written, remember, in 1939):

"Under the surface of the governmental regulation of the securities market, the same forces that produced the riotous speCUlative excesses of the 'wild bull market' of 1929 still give evidences of their existence and influence. Though repressed for the present, it cannot be doubted that, given a suitable opportunity, they would spring back into pernicious activity.

"Frequently we are told that this regulation has been throttling the country's prosperity."

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"The public is sometimes forgetful. As its memory of the unhappy market collapse of 1929 becomes blurred, it may lend at least one ear to the persuasive voices of The Street subtly pleading for a return to the 'good old times.' Forgotten, perhaps, by some are the shattering revelations of the Senate Committee's investigation; forgotten the practices and ethics that The Street followed and defended vlhen its own sway was undisputed in those good Old days.

"After five short years, we may now need to be reminded what Wall Street was like before Uncle Sam stationed a policeman at its corner, lest, in time to come, some attempt be made to abolish that post."

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"National City Bank grew to be not merely a bank in the oldfashioned sense, but essentially a factory for the manufacture of stocks and bonds, a wholesaler a~d retailer for their sale, and a stock speculator and gambler participating in some of the most notorious pools of the 'wild bull market' of 1929.

"But how was this possible? For surely, the layman will protest, the law does not permit a bank to engage in such activi ties. A bank, especially a national bank, is, or is supposed to be, sacrosanct, its power strictly limited by Act of Congress, and its activities carefully and regularly examined by skilled examiners.


"The layman is right. But he has reckoned without the ingenuity of the legal technicians and the complaisance of governmental authorities toward powerful financial and business groups during the lamented pre-New Deal era. With their superior advantages, a method was worked out I1hereby a bank could assume a veritable dual personality. In one aspect - the aspect which it presented to the bank examiner and as to which it was subj ect to governmental control - it observed strictly all the proprieties of a properly managed bank. In the other aspect, it knew no regulation and no limitations: it could, and did, engage in the most diverse, risky and un-banklike operations.

"The technical instrument which enabled the bank to carry on in this Dr. Jekyll-Mr. Hyde fashion was known as the 'banking affiliate. '"

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"Altogether, during the years 1928-1932, inclusive, and after deducting heavy losses of about $4 million for the depression years, 1931 and 1932, Albert Wiggin, the head of Chase National Bank, and his family corporations still showed a net income for the whole period of over $8.6 million. Not many Americans could look back, in 1933, upon so satisfactory a balance sheet.

"How were these millions made?  Mr. Wiggin was able to make an income many times in excess of his ($175,000) salary, in large part by using his unique opportunities as the trusted and all-powerful head of a great bank, for his personal advantage.  

"To assist him in his private operations, Mr. Wiggins formed no less than six corporations, all of them owned and controlled by himself or members of his immediate family. Three of these were Canadian corporations organized in the hope that they might prove useful in reducing income taxes ....

"Mr. Wiggin's private operations in Chase Bank stock for his own benefit, moreover, they were intimately intertwined with extensive and intricate manipulations of the same stock undertaken by the bank's own affiliates. The full story of these involved relationships is an incredible one."

As will be the relationships which inevitably grow from the legislation now being considered.



End.