Congress is once again looking at Banking Deregulation. Will it ignore the lessons of the past?

– Charles H. Keating Jr. and the Lincoln Savings and Loan scandals of the 1980’s

Washington Monthly – MARCH 1997 By L.J. Davis

"What has once happened will invariably happen again, when the same circumstances which combined to produce it shall again combine in the same way" -ABRAHAM LINCOLN

"Greed is healthy" – IVAN BOESKY

Last October, as the O.J. Simpson saga roared into its 2000th irritating hour
and the Whitewater hearings cost taxpayers yet another ten-grand, an equally
significant event quietly took place in the American justice system: Charles H.
Keating Jr. was released from jail.
You remember Charlie, the poster boy of the savings and loan catastrophe of
the 1980s. Well, despite his role in the regrettable disappearance of $2.5
billion in taxpayer-insured funds, Keating was released on October 3, following
a court ruling that jurors at his 1993 federal trial had been inappropriately
influenced by their knowledge of Keating’s conviction in California state court.
Keating’s state convictions had been overturned in April, because his trial
judge, the now notorious Lance Ito, had given improper instructions to the jury.
Then on December 2, the remainder of his criminal convictions were thrown out by
a federal district court in Los Angeles. The U.S. attorney’s office is still
deciding whether to retry the case.

But why revisit the Keating story now? Seven years have passed since his
Lincoln Savings and Loan became the symbol of an industry gone mad. Whole reams
of newsprint described his doings and his sins, and his face appeared so often
on the nightly news that it was imprinted on the collective consciousness of the
nation. The case is closed, the story is over, and Charlie Keating is ancient

Well, not quite.

By a curious paradox commonplace in financial crimes, only a fraction of
Keating’s antics–not including his intimate connection with Michael Milken,
another emblematic felon of the Decade of Greed–made it into the spotlight.
Reporters concentrated on his lavish lifestyle, the fact that he tried to buy
the Phoenix City Council, and that he was able to get one of his associates
appointed to the Home Loan Bank Board, the federal agency that monitored his
activities and had the power to stop him cold. (This was likened, correctly, to
John Gotti getting one of his sidekicks appointed deputy director of the FBI.)
It was also noted that he knowingly sold millions of dollars worth of valueless
securities to thousands of people; erected a pyramid to himself in the Arizona
desert in the form of a ridiculously extravagant hotel; and somehow managed to
mislay $2.5 billion of the taxpayers’ money. But much of what he did was never

There are a number of reasons for this. Most reporters have to make sense of
something by six o’clock in the evening, and major financial crimes such as
Keating’s involve the sort of mind-numbingly tedious, specialized analysis that
most reporters, their other virtues aside, are not trained to do. In addition,
complex financial crimes take days and weeks to explain in court, using language
heavily freighted with obscure terms. Even then, there is no guarantee that a
judge and jury will understand; therefore, prosecutors usually base their cases
on the simplest and most comprehensible of the criminal’s misdeeds–in Keating’s
case, robbing widows and orphans. As a result, the greater crimes are almost
never revealed, and their larger meaning remains unknown. True to form, Keating
and Milken’s greater misdeeds never saw the light of day. So why revisit them
now, aside from the fun in revealing an old but untold story–and, of course,
the entertainment value of Charlie Keating?

The answer is both simple and urgent: deregulation. While Congress’s drive to
free industry from the clutches of big government may not be quite as maniacal
as before last November’s elections, the urge is still deeply rooted in the soul
of the GOP–which, if you’ll recall, remains firmly in control of both houses.
And with the banking industry at the forefront of those clamoring to be freed
from their regulatory shackles, the nightmare of the S&L years could easily
happen all over again.
As a result, now may indeed be the perfect time to
explore the full magnificence of Keating’s big adventure–keeping in mind, of
course, that the next financial disaster, if it comes, will be infinitely

Free Rein

In 1982, flying in the face of everything known about banks, bankers, and
human nature when they are placed in the vicinity of a huge sum of money,
Congress passed the Garn-St. Germain Act. This deregulated the nation’s thrift
industry and threw wide the doors of the S&Ls to anyone with a plausible
story, a fistful of cash, and a visible desire to start doing all sorts of
wonderful and imaginative things with the taxpayer-insured deposits.

The passage of Garn-St. Germain found Keating at loose ends. The
home-building business he then headed was not in terrific shape, and although
President Reagan had tried to appoint him ambassador to the Bahamas–which would
probably have saved everybody a tremendous amount of trouble–the appointment
fell through when members of the Senate discovered that in 1979, the Securities
and Exchange Commission had filed a complaint against Keating and his
then-mentor, Ohio billionaire and big-time political donor Carl Lindner, for
allegedly violating anti-fraud, disclosure, and proxy provisions. (Lindner
eventually settled with the SEC for $1.4 million.) But Garn-St. Germain, Keating
was quick to realize, changed everything. True, he didn’t have enough money to
buy an S&L suitable to his purposes, but he knew Michael Milken. In turn,
Milken and his brokerage firm, Drexel Burnham Lambert, were looking for funds to
create their dreamed-of junk bond network. It was a meeting of minds.

The trick, Keating came to realize under the guidance of Milken, was not to
find just any old S&L, but a particular kind of S&L. Garn-St. Germain
had dramatically increased the powers of the thrifts and dramatically reduced
the powers of the federal watchdogs, but the states still had their own
regulations. By a happy chance, however, California had just passed a new law
allowing the owner of a thrift to invest 100 percent of his federally insured
deposits in anything, anything at all. Keating soon set his sights on a well-run
southern California thrift named Lincoln Savings & Loan.

In 1983, Milken’s Drexel underwrote a $125 million debt-offering for
Keating’s American Continental Corporation–an event largely overlooked by the
press. It was, California Commissioner of Savings and Loans William Crawford
later told the House Banking Committee, "window-dressing," meaning Drexel
managed to give Keating’s floundering ACC the appearance of ruddy good health
and luminous solvency. Next, Drexel underwrote a $56 million preferred stock
issue of ACC. Keating took $51 million of the money and bought Lincoln. In other
words, Drexel bought Lincoln for Keating. Drexel also secretly purchased a
substantial hunk of the thrift for itself. The firm reserved 10 percent of
Lincoln’s stock, a fact that Drexel and Keating tactfully failed to mention to
regulators until 1985, when they revealed their relationship so quietly the
regulators failed to notice it.

In buying Lincoln–where he never held an official position because, as he
later blurted out to a Seattle regulator, he "didn’t want to go to
–Keating committed a number of promises to writing. Among others, he
pledged to retain Lincoln’s experienced executives and to continue its slow,
steady, unglamorous (and sound) policy of basing its business on home loans.
Keating immediately did neither of these things. Lincoln all but suspended its
home loan operation, and company officers were replaced by ACC staffers who were
essentially devoid of banking experience. With his plan thus in place, Keating
set about purchasing $2.7 billion in junk bonds, almost all of them (or at least
the ones that regulators later inspected) from Drexel. And when examiners from
the Federal Home Loan Bank of San Francisco, Lincoln’s primary regulator, got
around to taking a good look at Keating’s notion of an S&L, they found a
number of strange and alarming things about Lincoln’s junk bonds.

"Lincoln’s Investment Department," San Francisco wrote in its confidential
examination report, "consisted of an executive vice president’ an investment
manager and two investment analysts…. Not one of these investment managers or
analysts had worked for an investment banking firm. Not one of their resumes
reflected pre-Lincoln experience in analyzing corporate debt or equity

Even so, an inexperienced investment staff can quickly become knowledgeable
as it performs the exhaustive, painstaking analysis of the companies and
financial instruments that are candidates for the institution’s investments.
This research and analysis, considered essential by virtually all investment
houses, is called "due diligence" Lincoln performed no due diligence.

Instead, when word reached Lincoln that the San Francisco examiners were on
their way, Arthur Andersen, the Big Eight accounting firm that was Lincoln’s
auditor, dispatched a team to "stuff the files" with the sort of documents that
other financial institutions consider vital to making investment decisions. But
Arthur Andersen didn’t do the job very well.

"[The] analyses prepared by Arthur Andersen in no sense document the
justification for securities purchases," said the examination report. "Nor were
they `due diligence’ reports in any meaningful sense…. They were essentially
cut-and-paste jobs"

The people at Lincoln and Arthur Andersen gave many and conflicting reasons
for this state of affairs, but to the examiners, the most persuasive explanation
came from Lincoln’s own in-house legal counsel, Mark Sauder. The cut and pasted
documents, Sauder said, had been put in the files for the examiners to find, and
for no other reason.

But it gets worse.

A soundly-run investment operation will hedge its bets by seeking the advice
of, and making its investments through, a number of different brokerage houses.
Lincoln, the examiners concluded, did neither of these things. Instead, "[i]n
the junk bond files that we have examined," wrote Professors Alan Shapiro and
Mark Weinstein of the University of Southern California in a study made for San
Francisco, "the only broker dealt with is Drexel Burnham Lambert"

The great danger of using a single broker is that an investment house (and
the people whose money it is investing) will fall prey to the brokerage’s hidden
agendas–agendas which often involve a broker’s desire to get rid of something
no prudent investor will touch. Indeed, even the most casual examination of
Lincoln’s junk bond purchases reveals a number of Mike Milken’s greatest hits,
together with some of his biggest dogs. For example, in 1986 Lincoln invested
$100 million in the Ivan Boesky Limited Partnership, with Drexel charging a $4
million brokerage fee. The investment constituted 246 percent of Lincoln’s junk
bond portfolio and a remarkable 57.5 percent of Lincoln’s net worth. Boesky was
the emblematic risk arbitrageur of the 1980s, and Lincoln’s examiners regarded
the Boesky investment as extraordinarily risky. If Boesky lost the thrift’s $100
million, he was not on the hook, Drexel was not on the hook, and Lincoln was not
on the hook. The taxpayers were.

"When examiners asked Lincoln for its analysis of this investment," the
government remarked, they found that "Lincoln’s written ‘analysis’ of a $100
million investment…consisted of a grossly inadequate two-page memorandum that
consisted largely of a report on a conversation with a broker who had a vested
interest in selling the notes" (Boesky later paid a $50 million fine and went to
jail for his financial misdeeds, taking Milken down with him. Lincoln got its
money back, but not the returns it had been promised; Lincoln would have been
better off putting the taxpayers’ money in a bank.)

The government’s conclusion: "Keating," says a lawsuit filed by the Federal
Deposit Insurance Corporation and the Resolution Trust, "purchased or sold junk
bonds as directed by the Milken Group"

Aside from his dealings with Drexel, what else did Keating do with
Lincoln’s–i.e., the taxpayers’–money? A lot of things, far too many to be
documented here. Keating made many strange loans and participated in weird real
estate deals. For example, in 1987 Lincoln made a $30 million loan to a company
controlled by two close political associates of Sen. Dennis DiConcini of
Arizona. The company was in terrible shape, the loan was unsecured, and it was
granted on a non-recourse basis: If DiConcini’s associates defaulted on the
loan, they didn’t have to repay it. A loan is rated at its face value–in this
case $30 million–plus accrued interest, and it is usually possible to recover
money when a loan is bad; the collateral can be seized and the salary of the
lender can be garnisheed. But DiConcini’s associates pledged no collateral, and
their company’s few assets were overshadowed by huge liabilities. When the
examiners looked at the loan, they estimated its value–to Lincoln, that is–at
$0. It was not a bad loan; it was a disastrous loan. It could not be repaid, it
would probably never be repaid, and it should never have been made to begin

"The transaction," Richard Newsom, senior examiner for the California
Department of Savings and Loans, told the Banking Committee, "was so strange in
its magnitude…to a company with liabilities off the chart. We felt that the
link to a U.S. Senator…should be brought to the attention of the appropriate
officials, the FBI…"

Clearly, Newsom had his suspicions. To understand what they were, a spot of
background is in order.

By 1987, when San Francisco made its examination of Lincoln, an alarmed
Federal Home Loan Bank Board was aware that Garn-St. Germain had created a
financial catastrophe of unknown dimensions. Under Chairman Edwin Gray, a Reagan
appointee of unusual integrity, the Bank Board began to impose a number of
existing but long-neglected rules in an attempt to restore a measure of sanity
to the situation. This move did not please the White House, and it did not
please Charlie Keating.

White House chief of staff Donald Regan tried to fire Gray, only to discover
that Gray had been appointed for a fixed term. The administration threatened to
have him arrested for enforcing the nation’s laws. James Miller III’s Office of
Management and Budget attempted to reduce Gray’s already-inadequate staff of
underpaid examiners. Keating took his own steps, which is where Senator
DiConcini enters the picture.

When most people bring the thrift crisis to mind, they recall the Keating
Five–Senators Glenn, Cranston, McCain, Riegle, and DiConcini–who met on
Capitol Hill with Gray’s San Francisco regulators in an attempt to head them
off. But most people are unaware that before this, there was the Keating Four
(the Five minus Riegle) who called Gray in to plead the cause of the man they
called "our friend" In many ways, this meeting was the far more important of the
two. Whereas the San Francisco regulators were well-informed about the
disastrous situation at Lincoln and gave the five Senators better than they got,
the meeting of the Keating Four targeted Chairman Gray, who had been instructed
to come alone, without his staff. Gray was in an impossible situation: Aware
Keating was loudly proclaiming that the chairman was engaged in a personal
vendetta, Gray had deliberately distanced himself from the examination; he knew
little about Keating or Lincoln. Now, worn down by his failing attempts to
restrain an industry spinning out of control and by the relentless attacks of
his own administration, Gray found himself ill-prepared to face the hostile

All of the Four (except Glenn, whose former chief of staff had been hired by
Keating at a princely salary) had received handsome contributions from Keating.
The group gathered in DiConcini’s office at the senator’s invitation. During the
meeting, DiConcini held on his lap a memorandum that outlined Keating’s terms
and conditions, as though Keating were a sovereign nation. If Gray would call
off his dogs and stop writing new rules, DiConcini explained, Keating would
agree to make some home loans. Gray, though shaken by this exhibition of
Keating’s raw political power, refused.
But Keating had many more strings in his bow. To rid himself of his tormentor,
he tried to hire Gray away from the Bank Board; Gray declined. Next, Keating
engaged the services of Alan Greenspan, then an economist in private practice,
as a paid flack. The future chairman of the Federal Reserve prepared two
remarkable documents. In the first, he announced that Lincoln was a new,
innovative, and soundly-run institution that "poses no foreseeable risk to
FSLIC" In the second, he analyzed a number of other new, innovative, and
soundly-run S&Ls and blessed their work. Not long after, all the thrifts on
Greenspan’s list had failed but one, and the survivor–although Greenspan didn’t
seem to know it–was not a thrift.

Keating pressed on. The Federal Home Loan Bank Board had three members, Gray
and two others. When two seats became vacant, Keating put forward his own
candidates, Professor George Benston, another of his paid academic flacks, and
Lee Henkel, a Georgia lawyer who was involved in number of poorly performing
enterprises to which Lincoln had loaned millions. Benston didn’t make the cut,
but the Reagan Justice Department gave Henkel a clean bill of health. During his
brief tenure on the Bank Board, Henkel proposed precisely one new regulation.
Out of the 3,000 S&Ls in the land, it would have benefited just two, one of
which was Lincoln. (Gray believed that Henkel was unaware of the other one.)
Shortly after Sen. William Proxmire revealed Henkel’s relationship with Keating
and Lincoln, however, Henkel declared that he was fed up and resigned.

Still, things were looking up for Charlie Keating. Gray’s term expired, and
he was succeeded by M. Danny Wall. Wall was a former top aide to Sen. Jake Garn,
the co-author of Garn-St. Germain, and a considerably more Keating-friendly
regulator. Wall’s dealings with Keating are a study in creative regulation. In
an unprecedented move, Wall allowed Keating to try to change his primary
regulator from the hated San Francisco Home Loan Bank to the one in Seattle. At
a meeting with Seattle regulators, Keating offered to effect the transfer by
establishing a bogus headquarters at a Utah thrift within Seattle’s district,
which he volunteered to purchase on the spot with a personal check. Seattle was
not amused. The transfer did not take place.

Nonetheless, Keating was able to negotiate a memorandum of understanding
(MOW) with Wall’s Home Loan Bank Board. It was, William Black, acting counsel
for San Francisco and the former deputy director of the Bank Board, told the
House Banking Committee, "the worst so-called enforcement document in
history…. the Agreement and the MOU were a virtual cease and desist
order…against the Bank Board."

In a second unprecedented move, San Francisco was ordered to suspend its
examination of Lincoln. A new team of examiners was assembled from the staffs of
Home Loan Banks around the country and placed under the direct control of Wall’s
office–a third unprecedented move. But get this: Wall’s examiners were
forbidden to read San Francisco’s report on Lincoln–unprecedented move No. 4.
The examiners were not permitted to look through Lincoln’s original documents
but were supplied with copies instead (unprecedented move No. 5). And in words
that no examiner could ever remember hearing from a superior’s lips–but which
bore certain echoes of the 1980s Alan Greenspan–the examiners were informed
that Lincoln was a new and imaginative kind of thrift that many people did not
It looked as though Keating was about to slip away again. But he had reckoned
without the state of California. In the last of many brazen moves, Keating began
to sell bonds issued by his holding company, American Continental. Bonds costing
hundreds of millions of dollars were sold to thousands of people, many of them
Keating’s salesmen particularly targeted the elderly, some of them
widows and orphans, and most of them citizens of California. The bonds were

Desperate to stop the sale but lacking the necessary powers, Commissioner
William Crawford of the California Department of Savings and Loans sent his own
small examination team to Lincoln, to see if his people could somehow put a
spoke in Keating’s wheel.

For years, Keating’s regulators had wondered how he always seemed to
anticipate their moves. The California regulators discovered one possible
explanation: The supposedly secure telephone line from their office in Lincoln
to Los Angeles headquarters had been bugged. Tracing the bug, they found that a
number of Keating’s executives could listen in on every word. Nonetheless,
Keating’s string had just about run out.

It was Keating’s habit to prowl through the rooms where regulators were
conducting examinations, uttering threats and imprecations and talking grimly of
personal lawsuits. On one of his tours, he encountered senior examiner Richard
Newsom. Under the terms of Keating’s understanding with Wall’s Bank Board,
federal regulators were forbidden to examine certain documents containing
information that Keating quite clearly wanted to keep to himself. Newsom,
however, was quite clearly examining them–something that Keating did not
hesitate to point out.

"Mr. Keating," Newsom replied, "I am from the state of California, and we did
not sign the memorandum of understanding. And you, sir, are in my jurisdiction"
It was over.

Largely because California had put some spine into a Federal examination that
had previously seemed devoted to keeping Keating in business at all cost.
Lincoln was seized by the government in 1989. But not before a truck emblazoned
with the words "document destruction" had pulled up to the Lincoln loading dock.
And not before Keating and his associates had managed to blow $2.5 billion of
the taxpayers’ money. Keating went to jail. Lincoln ceased to exist. Michael
Milken also went to jail, but not a single charge against him involved Lincoln,
the mulcting of the taxpayers, or the use of their money in creating a junk bond
market that disrupted the economy of the entire country.
The story has a sour
ending, but it ends. Or does it?

In the waning years of the 20th century, Newt Gingrich’s Washington strongly
resembles a place where nothing has been learned and everything forgotten. On
Capitol Hill, only a few aging progressive Democrats–and an equally small
handful of thoughtful Republicans like Jim Leach of Iowa–remember why the
country’s financial institutions were regulated in the first place: When
regulations are removed from a financial institution, the very kinds of illegal
behavior they were designed to prevent come roaring back with a vengeance.

This regression was all-too-vividly demonstrated during the S&L fiasco,
which the General Accounting Office estimates will cost the country close to
$380 billion. Today there is somewhere between 11 and 12 times that amount, also
taxpayer insured, in the nation’s banks. At the moment, the banks are humming
along quite nicely–and profitably–prevented from gambling away their federally
insured deposits by a law called Glass-Steagall. Glass-Steagall is an old law,
passed more than 60 years ago. In those 60 years, the United States has not
experienced a single system-wide banking calamity–and the United States was
once a country of many banking calamities. But although signed by Herbert
Hoover, Glass-Steagall was vigorously enforced by Franklin Roosevelt. And as
every modern Republican knows, old laws–especially old laws with FDR’s
fingerprints on them–are destined for the dustbin of history.

Fortunately, any gung-ho deregulators looking to muck around with the banking
system must first pass through Jim Leach, head of the House Banking Committee,
and one of perhaps four people on the Hill who understands a thing about the
industry. Unfortunately, the thoughtful Mr. Leach may pose an equally
dangerous–and more immediate–threat to the current system. While opposing
wholesale deregulation, Leach nonetheless believes the banking industry should
be "modernized " This means trashing Glass-Steagall, and replacing it with his
new bill that would allow banks to sell insurance and make "responsible
investments" in securities.

But experience suggests that the banks already have too much leeway in their
investment strategies, and that, if anything, regulation should be tightened.
During the 1970s and ’80s, the large institutions in the banking centers of New
York, Chicago, and San Francisco lent truckloads of money to the world’s less
developed countries and lost many billions when the customers could not repay
the loans. While the banks were recovering from the consequences of their own
stupidity, they gazed upon the real estate market of the 1980s, superheated as
it was by the wild extravagances of Keating and others of similar kidney, and
found it good. The money center banks made billions of dollars of real estate
loans–and lost a huge chunk of them. In addition, certain holes in
Glass-Steagall permit banks to purchase arcane financial instruments as a
speculation; money got lost there, too. By 1989, the giant banks Citicorp and
Chase Manhattan–and perhaps the Bank of America–were arithmetically insolvent,
which is a slightly complicated way of saying they were broke. The regulators
politely looked the other way while the banks put their houses in order. (It is
an unspoken axiom of the American government that a giant bank can under no
circumstances be allowed to fail.) The taxpayers lost no money.

Responsible conservatives like Leach argue that the world has changed, the
lessons of the past have been absorbed, and new laws are needed to allow U.S.
banks to compete on the world stage with institutions such as the Japanese
banks, which are unhobbled by outdated legislation. This is to ignore the fact
that the Japanese banks, having speculated wildly during the bubble economy, are
out of money, and remain open only because everybody tells the same lie: "Ain’t
nothin’ wrong here, pal."

With his reputation as a level-headed sort, Leach’s chances for loosening
banking laws are considerably stronger than those of the more indiscriminate
deregulation cowboys (and cowgirls) on Capitol Hill. Having introduced his bill
in January 1995, Leach enjoyed bi-partisan committee support until last June, at
which time partisan bickering convinced him not to put the measure to a
committee vote. On day one of the 105th Congress, however, he reintroduced the
bill, and the folks in his office say that, with the election over, "the
environment is different" and all parties seem more willing to negotiate in
order to get the Leach Bill passed. Nor does it appear that Clinton, who
continues slouching ever-farther toward the right in his desire to be viewed as
part of "the vital center," would prove to be an obstacle to "updating" banking laws.
To the contrary, this January The New York Times reported that representatives
of the banking industry were among those in attendance at one of the
DNC-sponsored White House koffeeklatches last May–as was Comptroller of the
Currency Eugene Ludwig. Among the topics discussed: the repeal of
Glass-Steagall. East Coast Bank chairman Hjaima Jonson told the Times that the
President was "an active participant" in discussing how Glass-Steagall could be
overhauled. In fact, rather than hindering the deregulation process, the
administration is considering doing Leach one better, by opening the way for
ownership of banks by commercial firms.

History tells us that even if well-meaning legislators replace current laws
with more industry-friendly measures, then sometime soon after, the American
people are likely to discover that their lawmakers have just bought them a mess
of pottage. Just something to think about as you ponder the fact that Charlie
Keating, like Michael Milken, is out of jail and on the prowl. Back in
Scottsdale, Ariz., with his family, Keating is confident he can vanquish any
remaining legal issues that may crop up. He is tan, rested, and–as Time
magazine noted last month in an interview with Keating–"itching to get back on
the horse."

LJ. DAVIS is a contributing editor of Harper’s magazine, a contributing
writer for Mother Jones magazine, and is writing a book on interactive

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