Savings and loan crisis

The savings and loan crisis was the greatest collapse of U.S. financial institutions since the 1930s. From 1986 to 1989, the Federal Savings and Loan Insurance Corporation (FSLIC), the insurer of the thrift industry, closed or otherwise resolved 296 institutions with total assets of $125 billion. An even more traumatic period followed, with the creation of the Resolution Trust Corporation (RTC) in 1989 and that agency’s resolution by mid-1995 of an additional 747 thrifts with total assets of $394 billion.

The combined closings by both agencies of 1,043 institutions holding $519 billion in assets contributed to a massive restructuring of the number of firms in the industry. From January 1, 1986, through year-end 1995, the number of federally insured thrift institutions in the United States declined from 3,234 to 1,645, or by approximately 50 percent.

Originally, the S&L crisis was seen as a uniquely American mishap. In fact, it was but one of a slew of banking crises around the globe. Since 1980 when the crisis began, fully two-thirds of the 182 nations that belong to the International Monetary Fund have suffered similar problems.

Background
The National Housing Act created the Federal Housing Administration (FHA). It insured private lenders against losses on loans; made loans to lenders; "insured" lender mortgages meeting certain criteria (including much longer loans up to 20 years in length, periodic payments by a borrower "not in excess of his reasonable ability to pay," and interest ceilings); established national mortgage associations that purchased and sold mortgages and issued securities funding such activity; and created the Federal Savings and Loan Insurance Corporation (FSLIC), which insured savings and loan (S&L) deposits.

The insuring of much longer mortgage loans is of key importance. In 1930, about 33% of American households owned their own homes and by 1990 that figure had risen to about 67%. The typical mortgage was 5 years in length ending in a balloon payment (principal plus interest). Even though these loans were usually renewed for another 5-year term and were a better reflection of natural scarcity, the system still drew accusations of favoring the upper middle class and the wealthy. The government solution, beginning with NHA 1934, was 20- and 30-year fixed-interest-rate mortgages repaid in small amounts over time to greatly boost house affordability.

While the savings and loan leagues had no use for most of the housing programs, they had promoted and supported the Home Loan Bank in the 1930s, and it became one of their main props. The S&L industry would eventually come to be destroyed by the replacement of the 5-year mortgage with the artificial 20-year amortized mortgage, plus regulatory and tax incentives that encouraged S&Ls to load over 80% of their asset portfolios with the new longer-term mortgages.

The system was surprisingly stable for a long time. In legend at least, from the end of World War II to about the mid-1960s, the sleepy and idyllic world of the S&L executive conformed to the rule of 3-6-3: pay your depositors 3%, earn 6% on their home loans, and be on the golf course by 3:00 p.m.

The beginning of the end came in about 1965. The rise in interest rates in the two decades after World War II posed little threat to S&Ls. The interest rate on 10-year T-bonds was 2.8% in 1953 and 4% by 1963. The yield curve remained normal throughout this period (i.e., short-term rates were lower than long-term rates). The years between 1965 and 1982 were a different story. By 1982, the rate on 10-year T-bonds was 13.9% and, even worse for S&Ls, the rate on 1-year T-bills was 14%. Not only had rates risen dramatically; the yield curve had inverted as well. The Fed had struck again. For S&Ls, the rule of 3-6-3 had turned into 8-6-0, quickly sinking them into heavier and heavier losses.

The Fed used Regulation Q (its authority to set maximum rates on time deposits given to it by the Banking Act of 1933) for the first time to lower (instead of raise) deposit rates in 1967. FDIC and FSLIC extended the rate ceiling over every institution they had jurisdiction over. Along came Henry Brown and Bruce Bent in 1971 with an innovation known as the money market fund (MMF) that was not subject to Regulation Q. Fidelity, Dreyfus, and Merrill Lynch quickly followed their example. Funds poured out of banks and thrifts into MMFs.

The crisis
In the late 1970s, the United States was suffering from serious stagflation, with unemployment rates rising to their highest levels since the Great Depression, and inflation soaring in the double digits.

To make matters worse, interest rates were rising (the prime rate ultimately reached 21.5 percent in 1982) and banks and savings-and-loans (S&Ls) institutions were constrained from allowing market rates on their savings accounts by Regulation Q. The S&Ls found themselves rapidly losing reserves, and people pulled their money from the low-interest accounts and put them into money-market accounts. To make matters worse, a number of S&Ls had mortgages being paid back at interest rates of 5 and 6 percent, which meant they were losing money.

The 1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA), a sweeping legislation toward banking and financial "deregulation", did away with the limitations of the Regulation Q.

By 1981, almost all S&Ls were reporting losses, and their liabilities exceeded the value of their assets -- largely home mortgages. Congress played legislative catch-up for the rest of the decade. In 1980 and 1982, S&Ls were set free to become more like commercial banks, which had remained largely immune to risks inherent in borrowing at short-term interest rates while lending at long-term rates. The S&Ls mostly rushed into commercial real estate. Congress also bought time by lowering the capital requirements for S&Ls, encouraging yet greater leverage in real estate investments.

The real estate collapse had its roots in an artificial boom created not only by Federal Reserve policies, but also from tax laws. The 1981 Economic Recovery Tax Act (ERTA) significantly stimulated the commercial and residential real-estate market. The resulting real-estate boom led to serious overbuilding and price increases in real estate, especially in some geographic areas. The real-estate boom also contributed to the longstanding but deepening difficulties of the S&L industry as it attempted to salvage itself by participating in an increasingly speculative and artificially sustained market.

The commercial real estate market stumbled badly in the mid-1980s with the precipitous decline of energy prices and federal tax reform. The former produced a regional recession in the Southwest, while the latter drove down commercial real estate prices by eliminating some juicy tax breaks.

Every year after 1981, the Reagan administration agreed to continuing tax increases. The topper was the bipartisan Tax Reform Act of 1986, which lowered upper income rates some more, but again clobbered the middle class by wiping out a large number of tax deductions, in the name of "closing the loopholes." One of those "loopholes" was the real estate market, which lost most of its tax deductions for mortgages and tax shelters.

The Tax Reform Act reversed ERTA’s provisions by extending the depreciation period for commercial real estate from 15 to almost 32 years and by eliminating the preferential tax treatment of capital gains. In addition, the 1986 Act reduced the top marginal tax rate from 50 percent to 33 percent, thus reducing the tax savings per dollar of deduction associated with depreciation costs or real-estate losses. The overall effect of the 1986 legislation was to eliminate the tax incentive to hold commercial real estate. This dramatic change in tax policy was the primary initiating factor in the collapse of the real-estate market that began in 1987.

Since most savings and loans had their portfolios tied up in real estate, it was not surprising that many of them faced insolvency when the real estate values plummeted in the late 1980s. This "doomsday" scenario was made worse by the fact, that in 1983 perhaps half of the S&Ls had negative net worth.

Then things got ugly. In 1989, Congress shuffled regulatory bureaucracies, raised capital requirements and, ironically, required S&Ls to retreat to home lending, where they had first gotten into trouble. Compounding the damage, they forced institutions into a fire sale of their relatively modest portfolios of high-yield bonds, which had performed well throughout the decade. Last, but hardly least, Congress eliminated "goodwill" as an asset in S&L portfolios, pulling the rug out from under many institutions and adding a potential $50-billion of taxpayer liability, when the Supreme Court agreed that the government could be sued for reneging on what amounted to contracts.

Consequences
To dispose of nearly $1-trillion worth of assets seized from failed S&Ls, Congress established the Resolution Trust Corp. The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) was part of a broader wave of financial re-regulation that hamstrung the government in recovering the full value of assets in liquidations. These regulatory shifts helped precipitate the 1990 recession, during which banks and S&Ls reduced loans by about eight times the amount of their decline in capital.

Since small-business borrowers have fewer substitute sources of credit available to them than large ones, the decline in bank lending disproportionately affected their ability to spur innovation and long-term economic growth. The outcome was thus the worst of all possible worlds: a national recession triggered by an excess supply of real estate, the needless destruction of asset values and greater liabilities for taxpayers. The S&L crisis has echoes in the recent East Asian crisis and other banking crises around the world. Excessive government intervention has limited allowable activities, hobbling financial institutions' attempts to reinvent themselves by diversifying both their assets and liabilities.

The absence of efficient capital markets, and dependence on ossified banking systems, has left these countries with daunting resolution costs. It will cost Mexico about 19% of its annual GDP, compared with just 2% to 3% of America's GDP in the S&L crisis.

In August of 1989, after 10 years of crisis, Congress authorized outlays of more than $150-billion to close failed S&Ls that should have been liquidated years earlier. Rather than admit to its own mismanagement, Congress used FIRREA to deflect blame to directors, officers, lawyers, accountants and others who had been caught at the tiller when the system sank into insolvency.

Only about 4% of the cost of the debacle resulted from private fraud (and this because state regulators left the S&Ls' vault doors open). The largest portion (29%) consisted of the state fraud of $43 billion in interest costs accrued because zombie S&Ls were kept on life support by regulators hiding their balance-sheet deficiencies with accounting gimmicks.