WHAT HAPPENED TO

OUR $325 BILLION?

Michael Milken is only part of a much bigger financial scandal,

argues James Bowman Washington WHERE are we to seek for the truth about Michael Milken, who is variously hailed as a genius and reviled as a villain? He is not, like Richard Nixon, a difficult and complex character who approaches tragic stature. On the contrary, he's a fairly average guy who had a brilliant idea and a network of very rich friends who believed in it — and him. The idea was 'junk bonds' — high risk securities which fed the takeover fever of the '80s. The friends were, at least in the beginning, shrewd investors and entrep- reneurs who saw in this method of finance — by debt rather than by equity — a means of shaking up complacent and sclerotic corporate giants or starting new and highly capitalised high-tech enterprises. Milken's biggest mistake may have been, as John Makin of the American Enterprise Insti- tute says, making half a billion dollars a year publicly.

When he appeared in court in New York last week to plead guilty to six counts of a government indictment that originally comprised 98 counts, he burst into tears of shame. But the tears might as well have been those of frustration and bewilderment at the diversity of his characterisation in the press. To Richard Breeden, chairman of the Securities and Exchange Commis- sion, 'he stood at the centre of a network of manipulation, fraud and deceit'; to the influential columnists Rowland Evans and Robert Novak his hounding by federal prosecutors suggested police state tactics; to Haynes Johnson of the Washington Post he became a symbol of the greed and selfishness that characterised the era' of the '80s; to George Gilder, a prolific author on economic and social issues, Milken was rather the keystone of the arch sustaining our 'passage from the economics of matter to the economics of mind'. That's a Good Thing, by the way.

Although he has to pay $600 million in fines and prospective settlements of actions arising out of the case, sentencing will not take place until October. He could get 28 years in prison. There is also a variety of sentiment on that count. Some think prison is too good for him. Rabbi Arnold Wolf of Chicago said, 'He should be hung by his thumbs for years and years and years. He's a very terrible person.' A former business associate, on the other hand, thinks he shouldn't go to prison at all (`You don't put Michelangelo or da Vinci in jail. To lose that mind for even a day would be a tragedy'): instead he should be put in charge of tidying up the country's savings and loan scandal.

There is a considerable amount of chutz- pah in that suggestion from Mr Charles `We've gone into the red, but it's rather a nice shade.' Keating, the failure of whose Lincoln Savings and Loan will cost American tax- payers some two and a half billion dollars, but it does point us towards one of the reasons why Milken has drawn down upon himself the wrath of so many financial commentators: Uncle Sam is going to have to pay, according to the latest estimate, at least $325 billion, repeat, $325 billion, over the next 30 years to depositors in a host of bankrupt building societies, known in America as savings and loan associations; no one knows quite whom to blame for this, but because Milken sold a lot of his junk bonds to those institutions he seems to many a good candidate for scapegoat. Benjamin Stein, a novelist and financial writer, calls him 'the premier financial swindler of all time' because of his junk bonds' contribution to the crisis in the thrifts. Even the respected financial week- ly, Barron's, says that Milken bears a responsibility for the mess 'as much as any single individual'.

Well, there were a lot of individuals. In fact, only 3 or 4 per cent of the bad debts of the failed S & Ls were in junk bonds; only half a dozen or so of the hundreds which have gone or are going out of business got into trouble for that reason. In any case, it might be argued that the onus of blame should be upon those who bought them rather than the man who sold them with the clear warning that they were very risky investments. But there is only one of him and many of the fools and knaves who, trusting in his earlier successes, purchased his wares in the belief that he would make them rich. It is therefore natural if unfair that blame should accrue to the salesman rather than the eager suckers who wanted nothing better than to be sold more such junk.

No. There is a tale of fraud and corrup- tion to be told, but it is not Michael Milken's. What really lies behind the story of those missing billions is political cowar- dice and corruption so widespread throughout the US government as to be systemic. For ten years after their prob- lems became apparent, the S & Ls success- fully lobbied Congress for legislation which, it turns out, has only made things worse. Haunted by the political spectre of `endangering the nation's housing finance' and encouraged by campaign contributions from influential thrift owners, the nation's legislators not only kept the industry afloat when it was dead in the water but even, in some cases, intervened with regulators to prevent their attempts to stem a further growth in government-guaranteed losses. Charles Keating involved no fewer than five US senators in postponing his bank- ruptcy. The Wright and Coelho scandals of last year were also entrammelled in the S & L mess.

Here's why the mess happened. The failures of banks and, to a lesser extent, savings and loans during the Great De- pression led to the introduction of deposit insurance, backed by the federal govern- ment, in the 1930s. Small savers (at first those with savings of no more than $5000) were assured of the safety of their money, so that there would be no more runs on the banks or other institutions covered by these federal programmes. Naturally, in return for its guarantees, the government expected those institutions to accept a certain amount of supervision from Washington. Among the rules which ap- plied to the savings and loans were strict limitations on the rates of interest which they could offer to depositors or charge to borrowers and on the proportion of their business not devoted to home mortgages.

The result was that the S & Ls had most of their assets in long-term, low-interest, fixed-rate mortgages (flexible rates were not then permitted) when the great infla- tion of the 1970s came along. As their liabilities were in short-term funds for which they could not pay an interest rate that would even match the rate of inflation, depositors moved their money out of the thrifts and into unregulated funds which could pay a real net interest rate. Congress raised the limit up to which each account was insured to $100,000 in 1980, but by that time inflation had taught people that there was more than one way in which they could lose their savings.

By June of 1981, Richard Pratt, then the head of the Federal Home Loan Bank Board, testified before the Senate Banking Committee that it would cost the taxpayer $50 billion to rescue the hundreds of thrifts that were insolvent at that time. Under pressure both from the industry and from the Reagan administration to adopt a cheaper solution, the Congress came up with the Garn-St Germain Act of 1982. This is commonly referred to by the Left, which attributes to it all the industry's subsequent troubles, as 'deregulation', but in fact it was only partly that. It removed obstacles to the individual ownership of S & Ls, to the offering and asking of com- petitive rates of interest and to diversifica- tion of investment into other things besides mortgages, but it left intact the mechanism of federal deposit insurance.

In other words, Garn-St Germain was an attempt to cast the thrifts into the turbulent waters of the free market with a life jacket on: they could swim but they couldn't sink. The assumption was that they would grow out of trouble as the economy grew, and for a while it seemed to work like that. But for would-be owners of savings and loans it was like being invited to a gaming table where, for a minimum start-up cost of $2 million, they could keep their winnings but their losses would be covered by the house. No wonder that by the mid-1980s, as John Makin says, you were a fool if you didn't own an S & L.

And, as might have been expected, a lot of the clever chaps who did were crooks. Developers, estate agents, mafiosi and other assorted businessmen got into the game of thinking of a number — a large number — and paying that amount in dollars to themselves out of their own or a friend's S & L in the form of a loan which went into the books as an asset but which no one had any intention of paying back. To cover themselves they would shift their deposits around among those in the know and bid up short-term deposits from de- posit- brokers working on behalf of trusts or pension funds, some of whom were taking kickbacks. Also, crooked appraisers over- valued property on which loans were made so that their rotten assets went onto the books as bijou properties so that they then could be sold on (as 'participations) to other institutions. Meanwhile, federal ex- aminers whose job it was to spot such things were fewer in number and — for reasons which have yet satisfactorily to be explained — less sharp-eyed than they used to be.

Nevertheless, although there were so many crooks in the thrift industry that Attorney General Thornburgh announced last week that the Justice Department did not have the staff to prosecute them all, two thirds of the institutions that went bust did so legitimately. After the tax reform Act of 1986, real estate became a less attractive investment because it was a much less efficient tax shelter; prices fell sharply and with a domino effect in what was still by far the principal form of S & L investment. One after another the thrifts found that they could not meet the obliga- tions on their short-term deposits, interest rates on which shot up as they became desperate for cash. When they began to go under, it was left to the government's deposit insurance scheme and — when those funds were swiftly wiped out by the debacle — the taxpayers not only to pay off the depositors but to dispose of the de- valued or fraudulent assets.

The problem was coming to a head just as the Bush administration took office and legislation was rushed through the Con- gress last summer which provided for $50 billion in working capital and a whole new supervisory bureaucracy to liquidate failed thrifts. The chief agency of that bureaucra- cy, the Resolution Trust Corporation, is now the largest financial institution in America, but, if it were private, it too would be bankrupt. The cost of holding its billions in what are proving to be all but unsalable assets is estimated at $20 million a day. The RTC is also handicapped by re-regulation, which has made purchases of intact S & Ls less attractive to buyers, by the general decline in real estate prices, which can only be exacerbated by the dumping onto the market all at once of properties acquired from institutions in receivership, and by a congressional remit which includes a number of social-welfare provisions designed to assist minority con- tractors and those in need of low-cost housing.

In addition, legislation stipulates that the RTC cannot sell too cheaply the $220 billion in assets it had taken over through March (only $30 billion worth had been sold) and political considerations dictate that those to whom they are sold cannot be seen to have made a killing at taxpayers' expense. All this is delaying the sell-off and driving up the cost of the bail-out, as is the Byzantine complexity of the bureaucracy which has responsibility for an operation which the Wall Street Journal calls a `financial Vietnam'. The first chairman of the RTC Oversight Board, Daniel Kear- ney, resigned in disgust in February be- cause of his lack of authority to do the job in an efficient way.

Now at last there are signs that the ballooning costs of holding these assets have concentrated the minds of the bureaucrats who remain. Last August, when the bail-out legislation was passed, it provided for $166 billion to solve the problem over ten years. Now the General Accounting Office estimates that it will cost $243 billion over the ten years and anything up to $500 billion altogether. As a result, the RTC has changed course and announced plans to sell off 141 busted thrifts in this calendar quarter. To the end of March it had managed to sell only 52 of the 400 it had taken over to date. Lots of luck. Like Mr Keating, I suspect that Michael Milken might have done a better job in sorting out this mess. But if he had, it could have been the likes of Keating rather than Milken facing the prospect of a prison term this week.