11.5 Savings and loan crisis

The Savings and Loan crisis was a pivotal event in American financial history. It exposed flaws in the S&L industry's business model and regulatory framework, leading to widespread failures and a costly government bailout in the 1980s and early 1990s.

The crisis stemmed from economic challenges, deregulation, and risky lending practices. It reshaped the banking landscape, prompting stricter regulations and industry consolidation. The S&L crisis offers valuable lessons on financial oversight and risk management that remain relevant today.

Origins of S&L industry

• Savings and Loan (S&L) institutions emerged in the 19th century as community-based financial organizations focused on promoting homeownership
• S&Ls played a crucial role in shaping the American housing market and contributed to the growth of suburban communities
• The industry's development reflects broader trends in American business history, including the rise of consumer finance and the government's role in economic policy

Great Depression reforms

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• Banking Act of 1933 established the Federal Savings and Loan Insurance Corporation (FSLIC) to insure S&L deposits
• Home Owners' Loan Corporation (HOLC) created to refinance distressed mortgages and prevent foreclosures
• Federal Home Loan Bank System established to provide liquidity to S&Ls
• These reforms aimed to stabilize the housing market and restore public confidence in financial institutions

Post-war housing boom

• G.I. Bill of 1944 provided low-interest mortgages to returning veterans, stimulating housing demand
• S&Ls became primary lenders for suburban home construction and purchases
• Rapid expansion of S&L industry with assets growing from $8.7 billion in 1945 to$45.7 billion in 1960
• S&Ls specialized in offering long-term, fixed-rate mortgages, aligning with the American dream of homeownership

Regulatory environment

• S&L industry operated under a unique regulatory framework designed to promote homeownership and community development
• Regulations shaped the business model of S&Ls, influencing their ability to compete with other financial institutions
• The regulatory environment for S&Ls reflects the broader trend of government intervention in the financial sector during the mid-20th century

Interest rate ceilings

• Regulation Q imposed caps on interest rates S&Ls could offer on deposits
• Intended to prevent excessive competition and ensure stability in the banking system
• Created a competitive disadvantage for S&Ls when market interest rates rose above the ceiling
• Led to disintermediation as depositors sought higher returns elsewhere (money market funds)

Restrictions on investments

• S&Ls limited primarily to residential mortgages and government securities
• Prohibited from offering checking accounts until 1980
• Geographic restrictions on lending, typically confined to local communities
• Asset-liability mismatch created by long-term, fixed-rate mortgages funded by short-term deposits

Economic factors

• Macroeconomic conditions in the 1970s and early 1980s significantly impacted the S&L industry
• Economic challenges exposed vulnerabilities in the S&L business model and regulatory framework
• These factors set the stage for the subsequent crisis and reflect broader trends in American economic history

Inflation in 1970s

• Consumer Price Index (CPI) rose from 3.2% in 1972 to 13.5% in 1980
• S&Ls faced increasing costs as interest rates on deposits rose with inflation
• Value of long-term, fixed-rate mortgages eroded in real terms
• Net worth of many S&Ls declined as assets lost value faster than liabilities

Volcker shock

• Federal Reserve Chairman Paul Volcker raised interest rates to combat inflation in 1979
• Federal funds rate peaked at 20% in June 1981
• Created severe financial strain for S&Ls with portfolios of low-yielding mortgages
• Many S&Ls became insolvent on a market-value basis but remained open due to regulatory forbearance

Deregulation and consequences

• Policymakers responded to S&L industry challenges with a series of deregulatory measures
• Deregulation aimed to increase S&L competitiveness and profitability
• These changes fundamentally altered the S&L business model and risk profile
• Reflects broader trends of financial deregulation in the 1980s under the Reagan administration

Garn-St Germain Act

• Passed in 1982 to address S&L industry challenges
• Eliminated deposit interest rate ceilings, allowing S&Ls to compete for funds
• Increased federal deposit insurance limits from $40,000 to$100,000 per account
• Relaxed restrictions on loan-to-value ratios and allowed adjustable-rate mortgages

Expanded S&L powers

• S&Ls permitted to diversify into commercial real estate lending and consumer loans
• Authorized to invest up to 40% of assets in commercial mortgages
• Allowed to offer demand deposits and engage in credit card operations
• Reduced net worth requirements, enabling S&Ls to operate with lower capital ratios

Crisis unfolds

• The S&L crisis emerged as a result of economic factors, regulatory changes, and industry practices
• Rapid expansion and risk-taking by S&Ls led to widespread insolvencies
• The crisis represents a significant episode in American financial history, highlighting the dangers of moral hazard and regulatory failure

Risky lending practices

• S&Ls engaged in speculative commercial real estate lending and junk bond investments
• Brokered deposits used to fund rapid growth and high-risk ventures
• Land flips and other fraudulent schemes employed to inflate asset values
• Inadequate underwriting standards and poor risk management led to mounting loan losses

Real estate market collapse

• Oversupply of commercial real estate in many markets (office buildings, shopping centers)
• Tax Reform Act of 1986 eliminated key real estate tax shelters, reducing property values
• Regional economic downturns (oil price collapse in Texas, defense spending cuts in California)
• Widespread defaults on commercial real estate loans held by S&Ls

Government response

• Federal regulators and policymakers implemented various measures to address the S&L crisis
• The government response aimed to stabilize the financial system and protect depositors
• These actions had significant implications for taxpayers and the structure of the financial industry

FIRREA legislation

• Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) passed in 1989
• Abolished the Federal Home Loan Bank Board and created the Office of Thrift Supervision
• Established the Resolution Trust Corporation (RTC) to manage and sell assets of failed S&Ls
• Imposed stricter capital requirements and lending restrictions on surviving S&Ls

Resolution Trust Corporation

• RTC tasked with resolving 747 insolvent S&Ls between 1989 and 1995
• Employed various resolution methods (purchase and assumption, insured deposit transfers)
• Managed the sale of over $400 billion in assets from failed institutions
• Innovative approaches to asset disposition (securitization, bulk sales, equity partnerships)

Bailout and costs

• The S&L crisis required a massive government intervention to protect depositors and stabilize the financial system
• The bailout represents one of the largest financial rescue operations in U.S. history
• The costs and consequences of the crisis had long-lasting effects on the economy and public policy

Taxpayer burden

• Total cost of the S&L bailout estimated at $124 billion to$132 billion
• Approximately $87 billion paid directly by U.S. taxpayers through FSLIC and RTC funding
• Additional costs borne by the thrift industry through higher deposit insurance premiums
• Represented a significant portion of the federal budget deficit in the early 1990s

Long-term economic impact

• Contributed to the 1990-1991 recession by restricting credit availability
• Reduced public confidence in financial institutions and regulators
• Led to consolidation in the banking industry as many S&Ls were acquired by commercial banks
• Influenced subsequent debates on financial regulation and government intervention in markets

Key figures and institutions

• The S&L crisis involved numerous individuals and organizations that played significant roles
• Examining these key players provides insight into the complex dynamics of the crisis
• The actions of these figures and institutions highlight issues of corporate governance, regulatory oversight, and political influence

Charles Keating

• Chairman of Lincoln Savings and Loan Association in Irvine, California
• Engaged in high-risk investments and alleged fraudulent activities
• Involved in the "Keating Five" scandal, where five U.S. senators were accused of improper intervention
• Lincoln's failure in 1989 cost taxpayers $3.4 billion, one of the largest losses in the S&L crisis

Lincoln Savings and Loan

• Acquired by Charles Keating's American Continental Corporation in 1984
• Grew rapidly from $1.1 billion in assets in 1984 to$5.5 billion in 1988
• Invested heavily in junk bonds and speculative real estate projects
• Sold uninsured subordinated debentures to depositors, leading to significant losses for many investors

Lessons and legacy

• The S&L crisis provided valuable lessons for policymakers, regulators, and financial institutions
• The aftermath of the crisis led to significant changes in the regulatory landscape and industry practices
• These lessons continue to influence debates on financial regulation and risk management

Financial regulation reforms

• Stricter capital requirements implemented for depository institutions
• Enhanced supervisory and enforcement powers granted to regulators
• Improved accounting standards and disclosure requirements for financial institutions
• Creation of the prompt corrective action framework to address troubled banks earlier

Impact on banking industry

• Consolidation of the banking sector as many S&Ls were acquired by commercial banks
• Shift away from the traditional S&L model of portfolio lending towards securitization
• Increased focus on risk management and internal controls within financial institutions
• Greater emphasis on diversification and liquidity management in bank operations

S&L crisis vs 2008 financial crisis

• Comparing the S&L crisis to the 2008 financial crisis reveals important similarities and differences
• Both crises highlight recurring issues in financial regulation and risk management
• Understanding these parallels and distinctions provides valuable context for analyzing financial crises

Similarities in causes

• Both crises rooted in real estate market speculation and lax lending standards
• Regulatory failures and inadequate oversight contributed to both crises
• Financial innovation and deregulation played roles in amplifying risks
• Moral hazard issues arising from government guarantees and implicit bailout expectations

Differences in scale

• 2008 crisis involved a broader range of financial institutions and markets
• Systemic risk more pronounced in 2008 due to interconnectedness of global financial system
• Complexity of financial instruments (CDOs, CDSs) greater in 2008 crisis
• Government response in 2008 more extensive, including unconventional monetary policy measures

Cultural impact

• The S&L crisis left a lasting impression on American culture and society
• Public perceptions of financial institutions and government regulators were significantly affected
• The crisis inspired various cultural representations that reflected and shaped public understanding

Public perception of banks

• Erosion of trust in financial institutions and their leaders
• Increased skepticism towards claims of financial expertise and self-regulation
• Greater public awareness of the potential for fraud and mismanagement in banking
• Calls for stronger consumer protection measures and financial literacy education

Representations in media

• Films like "Wall Street" (1987) reflected the era's financial excesses and moral ambiguity
• Books such as "The Best Way to Rob a Bank Is to Own One" by William K. Black examined the crisis
• Television shows (L.A. Law) incorporated storylines related to S&L failures and financial fraud
• Political cartoons and satirical works critiqued the government's handling of the crisis