[An updated version of this article can be found at Savings and Loan Crisis in the 2nd edition.]
The extraordinary cost of the S&L crisis is astounding to every taxpayer, depositor, and policymaker. The estimated present value cost of the bailout of the Federal Savings and Loan Insurance Corporation (FSLIC) is $175 billion or more. Present value means the dollar amount of a check written today that would pay the full cost of cleaning up the S&L mess.
The bankruptcy of FSLIC did not occur overnight; the FSLIC was a disaster waiting to happen for many years. Numerous public policies, some dating back to the thirties, created the disaster. Some policies were well-intended but misguided. Others lost whatever historical justification they might once have had. Yet others were desperate attempts to postpone addressing the reality of a rapidly worsening situation. All of these policies, however, greatly compounded the S&L problem and made its eventual resolution more difficult and much more expensive. When disaster finally hit the S&L industry in 1980, the federal government managed it very badly.
Fifteen public policies that contributed to the S&L debacle are summarized below.
Public Policy Causes with Roots before 1980
Federal deposit insurance, which was extended to S&Ls in 1934, was the root cause of the S&L crisis because deposit insurance was actuarially unsound from its inception. That is, deposit insurance provided by the federal government tolerated the unsound financial structure of S&Ls for years. No sound insurance program would have done that. Federal deposit insurance is unsound primarily because it charges every S&L the same flat-rate premium for every dollar of deposits, thus ignoring the riskiness of individual S&Ls. In effect, the drunk drivers of the S&L world pay no more for their deposit insurance than do their sober siblings.
Borrowing short to lend long was the financial structure that federal policy effectively forced S&Ls to follow after the Great Depression. S&Ls used short-term passbook savings to fund long-term, fixed-rate home mortgages. Although the long-term, fixed-rate mortgage may have been an admirable public policy objective, the federal government picked the wrong horse, the S&L industry, to do this type of lending since S&Ls always have funded themselves primarily with short-term deposits. The dangers inherent in this "maturity mismatching" became evident every time short-term interest rates rose. S&Ls, stuck with long-term loans at fixed rates, often had to pay more to their depositors than they were making on their mortgages. In 1981 and 1982 the interest rate spreads for S&Ls (the difference between the average interest rate on their mortgage portfolios and their average cost of funds) actually were -1.0 percent and -0.7 percent respectively.
Regulation Q, under which the Federal Reserve since 1933 had limited the interest rates banks could pay on their deposits, was extended to S&Ls in 1966. Regulation Q effectively was price-fixing, and like most efforts to fix prices (see Price Controls), Regulation Q caused distortions far more costly than any benefits it may have delivered. Regulation Q created a cross-subsidy, passed from saver to home buyer, that allowed S&Ls to hold down their interest costs and thereby continue to earn, for a few more years, an apparently adequate interest margin on the fixed-rate mortgages they had made ten or twenty years earlier. Thus, the extension of Regulation Q to S&Ls was a watershed event in the S&L crisis: it perpetuated S&L maturity mismatching for another fifteen years, until it was phased out after disaster struck the industry in 1980.
Interest rate restrictions locked S&Ls into below-market rates on many mortgages whenever interest rates rose. State-imposed usury laws limited the rate lenders could charge on home mortgages until Congress banned states from imposing this ceiling in 1980. In addition to interest rate ceilings on mortgages, the due-on-sale clause in mortgage contracts was not uniformly enforceable until 1982. Before, borrowers could transfer their lower-interest-rate mortgages to new homeowners when property was sold.
A federal ban on adjustable rate mortgages until 1981 further magnified the problem of S&L maturity mismatching by not allowing S&Ls to issue mortgages on which interest rates could be adjusted during times of rising interest rates. As mentioned above, during periods of high interest rates, S&Ls, limited to making long-term, fixed-rate mortgages, earned less interest on their loans than they paid on their deposits.
Restrictions on setting up branches and a restriction on nationwide banking prevented S&Ls, and banks as well, from expanding across state lines. S&Ls, unable to diversify their credit risks geographically, became badly exposed to regional economic downturns that reduced the value of their real estate collateral.
The dual chartering system permitted state-regulated S&Ls to be protected by federal deposit insurance. Therefore, state chartering and supervision could impose losses on the federal taxpayer if the state regulations became too permissive or if state regulators were too lax.
The secondary mortgage market agencies created by the federal government undercut S&L profits by using their taxpayer backing to effectively lower interest rates on all mortgages. This helped home buyers, but the resulting lower rates made S&L maturity mismatching even more dangerous, especially as interest rates became more volatile after 1966.
Public Policy Causes That Began in the Eighties
Disaster struck after Paul Volcker, then chairman of the Federal Reserve board, decided in October 1979 to restrict the growth of the money supply, which, in turn, caused interest rates to skyrocket. Between June 1979 and March 1980 short-term interest rates rose by over six percentage points, from 9.06 percent to 15.2 percent. In 1981 and 1982 combined, the S&L industry collectively reported almost $9 billion in losses. Worse, in mid-1982 all S&Ls combined had a negative net worth, valuing their mortgages on a market-value basis, of $100 billion, an amount equal to 15 percent of the industry's liabilities. Specific policy failures during the eighties are examined below.
An incomplete and bungled deregulation of S&Ls in 1980 and 1982 lifted restrictions on the kinds of investments that S&Ls could make. In 1980 and again in 1982, Congress and the regulators granted S&Ls the power to invest directly in service corporations, permitted them to make real estate loans without regard to the geographical location of the loan, and permitted them to lend up to 40 percent of their assets in commercial real estate loans. Congress and the Reagan administration naïvely hoped that if S&Ls made higher-yielding, but riskier, investments, they would make more money to offset the long-term damage caused by fixed-rate mortgages. However, the 1980 and 1982 legislation did not change how premiums were set for federal deposit insurance. Riskier S&Ls still were not charged higher rates for deposit insurance than their prudent siblings. As a result deregulation encouraged increased risk taking by S&Ls.
Capital standards were debased in the early eighties in an extremely unwise attempt to hide the economic insolvency of many S&Ls. The Federal Home Loan Bank Board (FHLBB), the now-defunct regulator of S&Ls, authorized accounting gimmicks that were not in accordance with generally accepted accounting principles. In one of the most flagrant gimmicks, firms that acquired S&Ls were allowed to count as goodwill the difference between the market value of assets acquired and the value of liabilities acquired. If a firm acquired an S&L with assets whose market value was $5 billion and whose liabilities were $6 billion, for example, the $1 billion difference was counted as goodwill, and the goodwill was then counted as capital. This "push-down" accounting—losses were pushed down the balance sheet into the category of goodwill—and other accounting gimmicks permitted S&Ls to operate with less and less capital. Therefore, just as S&Ls, encouraged by deregulation, took on more risk, they had a smaller capital cushion to fall back on.
Inept supervision and the permissive attitude of the FHLBB during the eighties allowed badly managed and insolvent S&Ls to continue operating. In particular, the FHLBB eliminated maximum limits on loan-to-value ratios for S&Ls in 1983. Thus, where an S&L had been limited to lending no more than 75 percent of the appraised value of a home, after 1983 it could lend as much as 100 percent of the appraised value. The FHLBB also permitted excessive lending to any one borrower. These powers encouraged unscrupulous real estate developers and others who were unfamiliar with the banking business to acquire and then rapidly grow their S&Ls into insolvency. When the borrower and the lender are the same person, a conflict of interest develops. Also, because developers, by nature, are optimists, they lack the necessary counterbalancing conservatism of bankers.
Delayed closure of insolvent S&Ls greatly compounded FSLIC's losses by postponing the burial of already dead S&Ls. Chart 1 shows how losses in insolvent S&Ls grew during the eighties as the closure of insolvent S&Ls was delayed. Mid-1983 would have been the optimum time to close hopelessly insolvent S&Ls. Instead, Congress chose to put off the eventual day of reckoning, which only compounded the problem.
Chart 1. FSLIC/RTC's Accumulation of Losses During the Eighties and Early Nineties
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A lack of truthfulness in quantifying FSLIC's problems hid from the general public the size of the FSLIC's losses. Neither the FHLBB nor the General Accounting Office (GAO) provided realistic cost estimates of the problem as it was growing. On May 19, 1988, for example, Frederick Wolf of the GAO testified that the FSLIC bailout would cost $30 billion to $35 billion. Over the next eight months, the GAO increased its estimate by $46 billion.
Congressional and administration delay and inaction, due to an unwillingness to confront the true size of the S&L mess and anger politically influential S&Ls, prevented appropriate action from being taken once the S&L problem was identified. The 1987 FSLIC recapitalization bill provided just $10.8 billion for the cleanup, while it was clear at the time that much more, possibly as much as $40 billion, was needed. The first serious attempt at cleaning up the FSLIC mess did not come until Congress enacted the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). Even FIRREA, however, did not provide sufficient funds to completely clean up the S&L mess.
Flip-flops on real estate taxation first stimulated an overbuilding of commercial real estate in the early eighties and then accentuated the real estate bust when depreciation and "passive loss" rules were tightened in 1986. The flip-flop had a double-whammy effect: the 1981 tax law caused too much real estate to be built and the 1986 act then hurt the value of much of what had been built.
What Did Not Cause the S&L Disaster
Some highly publicized factors in the S&L debacle—criminality, a higher deposit-insurance limit, brokered deposits, and faulty audits of S&Ls—did not cause the mess. Instead, these factors are symptoms or consequences of it.
Crooks certainly stole money from many insolvent S&Ls. However, criminality costs the taxpayer money only when it occurs in an already insolvent S&L that the regulators had failed to close when it became insolvent. Delayed closure is the cause of the problem, and criminality is a consequence. In any event, criminality accounts for only $5 billion, or 3 percent, of the probable cost of the FSLIC bailout.
Raising the deposit-insurance limit in 1980 from $40,000 to $100,000 did not cause S&Ls to go haywire. All that raising the insurance limit did was make it slightly less expensive administratively to funnel money into insolvent S&Ls. Put another way, had the deposit-insurance limit been kept at $40,000, a depositor intent on putting $200,000 of insured funds into insolvent S&Ls paying high interest rates would have had to deposit his money, in $40,000 chunks, into five different S&Ls. Because of the higher limit, two $100,000 deposits would keep the $200,000 fully insured.
Brokered deposits became an important source of deposits for many S&Ls in the eighties. Brokered deposits allowed brokerage houses and deposit brokers to divide billions of dollars in customers' funds into $100,000 pieces, search the country for the highest rates being paid by S&Ls, and deposit these pieces into different S&Ls. Brokered deposits, though, were the regulators' best friend because this "hot money," always chasing high interest rates, kept insolvent S&Ls liquid, enabling regulators to delay closing these S&Ls. Regulators, therefore, were the true abusers of brokered deposits.
Certified public accountants (CPAs) have been blamed for not detecting failing S&Ls and reporting them to the regulators. However, CPAs were hired by S&Ls to audit their financial statements, not to backstop the regulators. Federal and state S&L examiners, working for the taxpayer, were supposed to be fully capable of detecting problems, and often did. Interestingly, CPA audit reports also disclosed many financial problems in S&Ls, including regulatory accounting practices that were at odds with generally accepted accounting principles. The regulators, however, often failed to act on these findings. The CPAs, in effect, are being used as scapegoats for known problems the regulators should have quickly acted upon.
Junk-bond investments by S&Ls are often cited in the press and by politicians as a major contributor to the industry's problems. In fact, junk bonds played a trivial role. (Junk bonds are securities issued by companies whose credit rating is below "investment grade," which includes the vast majority of corporations in the United States.) A GAO report issued just five months before the passage of FIRREA cited a study by a reputable research group that showed junk bonds to be the second most profitable asset (after credit cards) that S&Ls held in the eighties. The report also pointed out that only 5 percent of the nation's S&Ls owned any junk bonds at all. Total junk-bond holdings of all S&Ls amounted to only 1.2 percent of their total financial assets. Even so, Congress mandated in FIRREA that all S&Ls had to sell their junk-bond investments.
The Future of S&Ls
Rapid technological change is destroying the old structure of the financial services industry and replacing it with a new structure. Computerization has unbundled home mortgage financing into three distinct industries—mortgage origination, mortgage funding, and mortgage servicing. Thus, integrated, specialized housing lenders such as S&Ls are no longer needed. As more and more insolvent S&Ls fail and are merged into healthier institutions—both banks and S&Ls—the badly needed consolidation of the deposit-taking industry will accelerate. Eventually, S&Ls probably will cease to exist as a separately regulated industry.
Bert Ely is head of Ely and Company, a financial institutions consulting firm in Alexandria, Virginia. He was one of the first people to publicly predict FSLIC's bankruptcy.
Ely, Bert. "Technology, Regulation, and the Financial Services Industry in the Year 2000." Issues in Bank Regulation 12, no. 2 (Fall 1988): 13-19.
Ely, Bert, and Vicki Vanderhoff. Lessons Learned from the S&L Debacle: The Price of Failed Public Policy. 1991.
Fand, David. "The Savings and Loan Debacle." Paper presented at the George Edward Durell Foundation Conference, "American Money and Banking: Fiscal Fitness in the 1990s?" May 21-22, 1991.
Hector, Gary. "Where Did All Those Billions Go?" Fortune, September 10, 1990.
Kane, Edward J. The Gathering Crisis in Federal Deposit Insurance. 1985.