Untitled
Lessons from the
Savings and Loan
Debacle
The Case for Further Financial
Deregulation
Catherine England
An
April 28, 1992, Washington Post editorial
warned, "Over the past decade the country
has learned a lot about the limits to deregu-
lation." The savings and loan crisis was, of course,
one exhibit called forth: "Deregulation also has its
price, as the savings and loan disaster has hid-
eously demonstrated. Deregulation, combined
with the Reagan administration's egregious fail-
ure to enforce the remaining rules, led to the
gigantic costs of cleaning up the failed S&Ls."
Such editorials demonstrate that the S&L fiasco
continues to be misdiagnosed. Unfortunately, this
misdiagnosis is being applied by many to the ail-
ing banking industry, and there are those who
would introduce the S&L cancer into the insur-
ance market and compound that industry's prob-
lems. In the absence of more careful attention to
the roots of the S&Ls' problems, taxpayers may
face further financial industry bailouts.
The S&Ls' experience yields three important les-
sons. First, excessive regulation was the initial
Catherine England is an economics consultant in
Alexandria, Virginia, and a professor of economics
at American University.
36 REGULATION, SUMMER 1992
cause of the industry's problems. Second, federal
deposit insurance was ultimately responsible for
the high costs of the debacle. Finally, government-
sponsored efforts to protect the industry only
invited abuses and increased the ultimate cost of
estructuring.
Prelude to Disaster
From the end of the depression through the 1960s,
the S&L industry represented an important cog
in the U.S. government's efforts to promote home
ownership, but the operation of individual S&Ls
was pretty cut-and-dried. S&Ls were required by
law and regulation to gather the savings of house-
holds in short-term deposits and invest those sav-
ings in thirty-year, fixed-rate mortgages secured
y property within a fifty-mile radius of the insti-
tution's home office. Savings deposits were feder-
ally insured through the Federal Savings and Loan
Insurance Corporation, and there were a handful
of state-sponsored deposit insurance funds.
Regional Federal Home Loan Banks were avail-
able to lend member institutions funds at subsi-
dized rates, and the industry had an official Wash-
ington advocate in the Federal Home Loan Bank
Board. Life at an S&L was not particularly excit-
ing before 1970, but owners could earn a reason-
ably stable living.
Unfortunately, those staid institutions con-
tained some fundamental flaws. Before 1980 S&Ls
did not face much "credit risk," because mortgages
epresent one of the safest forms of consumer
debt. What credit risk they did face was com-
pounded, however, by the fact that each institu-
tion served a limited geographic area.
More important was the "interest rate risk"
embodied in S&Ls' operations. As long as interest
ates remain fairly stable over long periods of
time, bo
owing short (raising passbook savings
deposits) and lending long (writing thirty-year,
fixed-rate mortgage contracts) can prove profit-
able. Interest rates on long-term contracts are nor-
mally higher than those on short-term instru-
ments, and houses are often resold and hence
efinanced before thirty years have elapsed. But
the risks of such a strategy remain, and those risks
finally came home to roost for S&Ls.
As inflationary expectations became more prev-
alent during the 1970s, interest rates became more
volatile and generally followed an upward trend.
Increased economic uncertainty coupled with ris-
ing interest costs depressed the housing market.
Homeowners kept their houses longer. First-time
homebuyers delayed their purchases. When
houses were sold, buyers more frequent!) invoked
the "assumable" clause in mortgage contracts that
allowed them to assume responsibility for the
emaining loan balance at the existing interest
ate. Mortgage portfolios that had traditionally
turned over every five years or so stagnated during
the late 1970s and early 1980s, and S&Ls' earnings
stagnated with them. In 1980 the average effective
yield on S&Ls' portfolios was 8.79 percent, while
the 1980 inflation rate stood at 12.4 percent.
Meanwhile, the industry also faced funding
problems. The rates S&Ls paid depositors were
controlled. Those interest rate ceilings were
designed to protect S&Ls from high funding costs,
ut as the 1970s progressed, S&Ls' customers
ecame increasingly disgruntled. Returns on sav-
ings of 5 1/4 to 5 1/2 percent fell far short when
inflation exceeded 12 percent.
Fortunately for savers, there was an alternative.
Money market mutual funds collected individuals'
savings, pooled them, and then bought, among
other things, large certificates of deposit ($100,000
or more) from banks and S&Ls. Because there
were no interest rate controls on those large CDs,
FINANCIAL DEREGULATION
money market mutual funds could demand, and
then pay, market rates of interest. Between 1978
and 1981 money market mutual funds grew from
$9.5 billion to $188.6 billion in assets, and many
of their customers came from banks and S&Ls.
Excessive regulation was the initial cause
of the S&L industry's problems. Federal
deposit insurance was ultimately respon-
sible for the high costs of the debacle.
Government-sponsored efforts to protect
the industry only invited abuses and
increased the ultimate cost of restruc-
turing.
Caught in a vise between stagnant incomes and
ising costs, the S&L industry's capital eroded. By
1980, before any deregulation had taken place,
the liabilities of the S&L industry exceeded its
assets by $110 billion. The industry was alrOlidy
insolventits members owed more than -they
ownedwhen Congress and the Carter adminis-
tration enacted the Depository Institutions Dereg-
ulation and Monetary Control Act of 1980.
Resuscitation Efforts
Policymakers focused on the symptoms of the sick
S&L industry in 1979 and 1980. To address the
problems created by a portfolio full of long-term,
fixed-rate assets, Congress and the administration
sought to offer S&Ls additional investment oppor-
tunities. Thus, adjustable rate mortgages were
finally allowed. The 1980 legislation and the Garn-
St Germain Depository Institutions Act of 1982
also expanded acceptable S&L investments by
permitting them to make short-term consumer
loans, issue credit cards, and make commercial
eal estate loans, among other things. Policymak-
ers hoped that
oader powers would allow S&Ls
to better diversify their portfolios so that they
could increase their short-term earnings and be
less vulnerable to future economic instability.
Policymakers also addressed S&Ls' funding
problems. The 1980 legislation initiated a six-year
phaseout of deposit interest rate ceilings and
encouraged the development of new, longer-term
savings instruments. In a last-minute conference
CATO REVIEW OF BUSINESS & GOVERNMENT 37
FINANCIAL DEREGULATION
"A $2 stock sounds wonderful. After all, how far down can
it possibly go?"
committee deal, Congress also expanded federal
deposit insurance coverage from $40,000 per
account to $100,000 per account.
Deregulation was a reasonable response
to the S&Ls' ills. Ove
egulation had
ankrupted the industry; it was logical to
expect that greater freedom would enable
S&L owners and managers to improve
their financial health. Unfortunately, poli-
cymakers overlooked one crucial step
ecapitalization.
In and of itself, deregulation was a reasonable
esponse to the S&Ls' ills. Ove
egulation had
ankrupted the industry; it was logical to expect
that greater freedom would enable S&L owners
and managers to improve their financial health.
Unfortunately, policymakers overlooked one cru-
cial steprecapitalization.
The Importance of Being Capitalized
When the corner grocery store or a national airline
ecomes insolvent, its creditors stop providing
further support and force the business into bank-
uptcy court. Creditors limit their contributions
to failing businesses, because as the owner's stake
38 REGULATION, SUMMER 1992
in a firm declines, the owner becomes less cau-
tious and more inclined to take greater risks in
an attempt to recoup past losses and restore the
firm to health. Such gambles sometimes pay off,
ut more often they only compound existing prob-
lems.
As the 1980s dawned, hundreds of S&Ls were
insolvent. Unlike creditors of other businesses,
however, savings and loan depositors, the primary
private creditors of decapitalized S&Ls, continued
to provide funding. Federal deposit insurance pro-
tected most S&L depositors from losses and made
the federal government the creditor of last resort
for weak institutions.
The federal government also failed to act as a
private creditor would have acted. Government-
sponsored financial support continued through
oth subsidized loans and continued deposit
insurance. S&L owners with little or none of their
own money at risk were thus given
oad new
powers and access to a virtually unlimited source
of funds. The results were disastrous. In unravel-
ling the events of the 1980s, it is helpful to consider
three groups of S&L owners and managers: honest
individuals operating weak or insolvent institu-
tions, the crooks and frauds, and the owners and
managers of healthy S&Ls.
Honest Managers of Weak Institutions. Imag-
ine a fifty-year-old owne
manager of an S&L
opened by his father. It is 1980, and he has help-
lessly watched his institution's capital erode. The
housing market has slowed to a virtual standstill,
and his customers have moved their savings to
money market mutual funds.
He is unhappy with general economic condi-
tions and the regulatory constraints that have
caused his problems, and he wants his congress-
man and senators to know about it. In addition,
he expresses the strongly held conviction that it
would be wrong to close hundreds of S&Ls with
financial problems not of their making. Then Con-
gress acts, granting him permission to make loans
and investments other than mortgages. In addi-
tion, the phaseout of interest rate ceilings is
egun.
At this point, most S&L executives set out with
every intention of restoring their institutions to
financial health. But some fundamental realities
face the management of insolvent financial insti-
tutions. Beginning from a situation where liabili-
ties exceed assets, managers cannot overcome
financial problems by pursuing a conservative
investment course. In the absence of a capital