(FORTUNE Magazine) – RONALD REAGAN hoped to go down in history as the President who shrank the government and unleashed the free-market system. He may be remembered instead as the head of an Administration that nationalized a big chunk of the U.S. savings and loan industry. The takeover started in April. California's big Beverly Hills Savings & Loan, whose $3 billion in assets included a passel of bum real estate loans, had just gone under. The Federal Savings & Loan Insurance Corporation (FSLIC), which insures deposits in most S&Ls, quietly took charge, dismissing Beverly Hills' management and board of directors. All told, FSLIC has seized 17 S&Ls with assets totaling nearly $15 billion (see chart). Edwin J. Gray, 50, chairman of the Federal Home Loan Bank Board, the agency that oversees FSLIC and regulates 3,200 federally chartered S&Ls, recently told Congress that he can ''foresee'' taking over an additional 70 grievously ill institutions this year and next. Though the un-Reaganite word ''nationalization'' never appears when the takeovers are announced, the government's de facto ownership is beyond dispute. In most cases FSLIC has closed down the insolvent thrift and created a new successor corporation, to which it has transferred the institution's deposits and loan portfolio. The new institution is a federally chartered mutual savings and loan -- one that is technically owned by its depositors. Sitting in the corner offices of these S&Ls are not bureaucrats but executives of healthy institutions brought in under FSLIC's new ''management consignment program.'' What counts, though, is that FSLIC assumes all the responsibilities and risks of an owner. It also appoints new directors, whom it can fire, and injects new capital for which FSLIC -- and not the depositors -- is at risk. Says Edward J. Kane, professor of banking at Ohio State University, ''It's just nationalization by another name.'' Gray grudgingly agrees: ''I suppose you could take that point of view. But we're doing what we have to do.'' GRAY has little choice. For several years FSLIC has been shoring up nearly 200 tottering thrifts with infusions of capital. It liquidated 25 terminal cases by paying off depositors or transferring their funds to sounder institutions. The agency got rid of scores of other troubled institutions by such means as buying up their bad loans and turning the S&Ls into acceptable marriage partners for robust thrifts and commercial banks. Meanwhile, however, dozens of other sick but surviving thrifts -- known in the industry as ''the crazies'' -- had gone on a reckless lending spree, hoping to make the kind of killing that would save them from bankruptcy. Gray's overworked examiners didn't realize what was going on until it was too late. The number of problem cases has been multiplying so rapidly, and the cures have become so expensive, that FSLIC's insurance fund is running dangerously low. With only $3.2 billion in unobligated reserves left in the kitty, vs. $3.9 billion a year ago, FSLIC can do little else with Beverly Hills and other afflicted thrifts than sit on them until it can replenish the fund. Gray and others have lofted a series of proposals that would inject as much as $8.5 billion of new money into FSLIC, but the proposals have touched off a dispute over who should foot the bill. Oddly, the insurance fund is facing its worst crisis at a time when the thrift industry as a whole appears to be on the mend. Jonathan E. Gray, a security analyst at the Sanford C. Bernstein & Co. brokerage firm, is forecasting profits of $5 billion to $6 billion in 1985, exceeding the record $3.9 billion S&Ls earned in 1978. That's quite a turnaround from 1981, when high interest rates brought $4.6 billion in losses and left the industry as a whole with almost no tangible net worth (FORTUNE, October 15, 1984). The industry is scarcely flourishing, however. For this year Gray is forecasting a slender 0.45% return on assets and an 11.5% return on shareholders' equity, which compares with 0.82% and 14.9% respectively in 1978. The industry's tangible net worth remains low, and it is concentrated among some 800 prospering S&Ls. S&Ls, in fact, are not one industry but three. Anthony M. Frank, chairman of First Nationwide Financial of San Francisco, which Ford Motor Co. recently agreed to buy from National Intergroup, divides the 3,200 thrifts into what he calls ''the haves, the could-be-agains, and the never-will-be's.'' By Frank's estimate, about 30% of S&Ls are haves. Another 60% are could-be-agains that stand a good chance of rebuilding their capital if interest rates stay down; they can also go on lessening their vulnerability to swings in interest rates by replacing their old, low-yielding, fixed-rate mortgages with adjustable- rate mortgages. WHAT FRANK CALLS the never-will-be's, others call the industry's walking zombies. They are simply waiting for the regulators to liquidate them or relieve them of bad loans so they can be sold. Prominent in this group are some 300 institutions, with assets of $90 billion, that the Bank Board considers insolvent or close to it. Healing or liquidating these thrifts as well as those already nationalized, Washington insiders say, could take an infusion of $6 billion into FSLIC's insurance fund in the near future and an additional $10 billion later on. Another 600 less wobbly but endangered thrifts are on the agency's watch list. Rescuing some of these could take billions more. At first glance it appears strange that FSLIC should be driven to the extreme step of nationalization now rather than in 1981 and 1982, when money was hemorrhaging from the whole industry. The problem then was different, however. The industry suffered temporarily from ''spread problems'' -- that is, thrifts were paying a higher interest rate on deposits than they were collecting on old fixed-rate mortgages. But while most thrifts were losing money, at least their loans were good, money was coming in, and S&Ls had some net worth to eat into. It made a certain amount of sense for the government to treat the worst cases by tossing them a couple of crutches and praying for lower interest rates. It was cheaper by the billions than liquidating them. The thrifts winding up in government hands now are more gravely ill. They hold billions in nonperforming loans carelessly made in the lending binge of the past several years. They are not only legally insolvent, in the sense of having no net worth; in industry jargon they are economically insolvent. Says William J. Schilling, until recently director of the Federal Home Loan Bank Board's Office of Examinations and Supervision: ''When you're an insolvent thrift that still has funds coming in, you can weather the storm. But when you have bad loans that do not produce an income stream, it becomes virtually impossible to operate.'' ALMOST AS BIZARRE as this collection of zombies is the role of Edwin Gray, a longtime Reaganite and champion of bank deregulation who has presided over their nationalization. Gray's only experience in the industry was as a vice president for public relations and government affairs at Great American First Savings Bank in San Diego. A major qualification for high office was apparently his fierce loyalty to Ronald Reagan, whom he served as press secretary when Reagan was governor of California. Later Gray became an aide at the White House, where he helped push through the 1982 Garn-St Germain bill. Among other things, this landmark law allowed thrifts to engage in a limited amount of commercial lending to business. Gray wears cuff links bearing the Seal of the President of the U.S., and a poster-size picture of Gray with President Reagan hangs in his office. Even his supporters, however, give him low marks as a manager, and his critics reportedly include White House Chief of Staff Donald T. Regan. Gray concedes he is ''thinking about'' resigning, and informed sources say he has been pounding the pavement for a new job. Gray once had the support of much of the industry but has been losing it fast as his worries about the drain on FSLIC's insurance fund have overshadowed his allegiance to deregulation. Gray now thinks thrifts should stay closer to their traditional low-risk business of residential mortgages. One of his favorite examples of deregulation gone astray, which he doesn't name in speeches, is Butterfield Savings & Loan, a Santa Ana, California, thrift, which lost $8 million as a Wendy's franchisee and an owner of another fast-food business. Butterfield is now one of the 17 basket cases in the management consignment program. Even more worrisome to the Bank Board chief is the thrift industry's growing role as a real estate developer. Increasingly S&Ls have been lending money for land acquisition and construction and becoming part owners of projects by taking equity stakes. Gray's criticisms are not quite on the mark. It's true that S&Ls have taken a shellacking on construction loans and some equity investments. But much of the thrift industry's misery arises from the types of loans S&Ls were allowed to make before Garn-St Germain: residential mortgages on apartment houses, condominiums, and retirement projects. These are riskier than loans on owner- occupied, single-family dwellings, but lenders are supposed to do their homework and screen applicants. In too many cases they didn't. They underwrote projects that Lewis Goodkin, the president of Goodkin Research, a real estate consulting firm in Fort Lauderdale, Florida, says were ''bummers from the beginning.'' An example is the Monte Carlo Country Club, a golf community in Fort Pierce, Florida. Sunrise Savings & Loan, a Florida thrift with $1.5 billion in assets, has lent more than $20 million to the developers of the project since 1983. The project is far from other developed areas, and sales of single-family homes ! have been abysmal. Sunrise has been unable to collect on this and other loans, and FSLIC took over the thrift in July. The government's policy of propping up sick thrifts, some critics charge, encouraged this kind of lending. The bad loans are concentrated in California, Florida, Texas, and other Sunbelt states, where in the real estate boom of the early 1980s high-risk projects looked like salvation to thrifts desperate for earnings to rebuild their capital. Many of the eager lenders were already on the regulators' watch list of shaky institutions. Keeping them alive were long-term, low-interest notes issued by FSLIC -- so-called paper capital -- and government-condoned accounting gimmicks that bolstered their reported net worth. THUS KEPT GOING, the S&Ls were tempted to gamble in the hope of creating some true net worth. What, after all, did they have to lose? If the loans panned out, the profits would save the S&L and the jobs of its bosses. If not, management could call in the regulators and walk away. Says Jerome Baron, a security analyst who follows S&Ls for the First Boston investment banking firm: ''It was as if they just wanted to hop in the car, hit the accelerator, and see how far they could go before they crashed.'' Once the regulators saw the crash coming, they tried to get a foot on the brake. In January, despite vehement opposition from Congress, the Bank Board issued a regulation limiting equity investments to 10% of an institution's assets and imposed a rule limiting the annual growth of S&L assets to 25%. S& Ls that want to exceed these limits need the Bank Board's okay. By the time this rule was announced, the regulators were already swamped with more basket cases than they could cope with. Turnover has been running 16% a year at the Bank Board's staff that examines and supervises S&Ls, and even higher at FSLIC. Career professionals and executives have been heading for the door in such numbers that Regan has reportedly launched an investigation to find out why. The reason, says one recently departed Bank Board official, is simple: ''We've been through hell and high water over the past few years. You can only operate that way so long.'' ILL EQUIPPED to manage the S&Ls it has been taking over, the Bank Board has remanded them to the custody of sound S&Ls. For lending their talent, the ''managing agents'' receive a monthly fee from the Bank Board. Chairman Frank of First Nationwide Financial, whose institution is running Beverly Hills Savings & Loan for a fee of $33,000 a month, grouses that the money doesn't adequately compensate First Nationwide for the drain on its management. If recent events are any guide, Gray will not have an easy time finding the money he needs to denationalize the S&Ls he has been taking over. The industry is against one proposed fix: merging FSLIC with the Federal Deposit Insurance Corporation, which insures deposits at commercial and savings banks; together, the two would have unobligated reserves of $20 billion. S&Ls are not exactly eager to conform to the standards of the FDIC, which requires banks to maintain primary capital equal to 5 1/2% of deposits, compared with the 3% required by FSLIC. Gray dropped another proposed solution after a loud howl from the industry. He wanted to collect $8.5 billion for FSLIC through a onetime special assessment equal to 1% of each S&L's deposits -- a step that would cause scores of institutions to go under. Thrifts are already chafing at a supplementary insurance premium, equal to one thirty-second of 1% of each institution's deposits, that FSLIC has been collecting each quarter since March. The added fee, on top of the insurance fund's regular annual premium of one-twelfth of 1% of deposits, has netted $750 million so far -- a sum dwarfed by FSLIC's needs. Gray's best hope for immediate cash is a plan to create a new federal agency that would sell off the $2.8 billion of apartment houses, warehouses, and office buildings FSLIC has picked up in buying bad loans from thrifts. Real estate has been accumulating faster than regulators can get rid of it. Gray hopes to set up an ''asset management corporation'' -- in essence a federal real estate brokerage firm -- through which FSLIC could get paid before the real estate is sold. UNDER A PROPOSAL floated by a group of industry executives with Gray's encouragement, the Bank Board would charter the asset management corporation, and FSLIC would contribute $500 million in properties to get it going. The 12 district Federal Home Loan Banks, which are collectively owned by federally chartered S&Ls and serve as their central banking system, would put in $1 billion. The district banks would also make sizable loans to the corporation, which would funnel the money to FSLIC and repay the district banks as it sold off properties. The plan's proponents say the corporation could get top dollar for the real estate it sells -- and perhaps even book a profit -- by hiring experienced real estate executives at salaries not restricted by government pay scales. Optimists believe the new corporation could be up and running early next year. But while the plan doesn't require congressional approval, it has been bogged down by questions from Congressmen and executives of district banks worried about a strain on the banks' resources. These institutions appear strong enough, however, to give FSLIC a hefty transfusion. They have about $10 billion in capital and could readily raise several billion more by selling bonds, enjoying low rates because of their status as quasi-government agencies. The law, moreover, gives Gray another recourse: he can compel the district banks to make unsecured loans to FSLIC. Even these resources could prove inadequate. So diseased is much of the thrift industry that taxpayers may eventually have to bail out the insurance fund. The government's best hope is to steer clear of policies that would turn more thrifts into crazies. By curbing reckless growth and adequately supervising S&Ls, the Bank Board can prevent future lending sprees. And Washington should remove the hurdles that make it difficult for commercial banks and financial service companies to strengthen the industry by buying S& Ls. For too long Congressmen and regulators have heeded the pleas of S&L executives who want the hurdles kept in place so they won't have to compete with thrift institutions run by deep-pocketed financial giants.

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