The Fall of the Savings and Loan Industry

The savings and loan model depended on reliable payment of a relatively low and fixed rate of interest for deposits to allow a somewhat higher but fixed rate of interest for mortgagors.

The first sign of trouble came in 1965 when for the first time since the Great Depression, the deposit ceiling set by Regulation Q proved to be too low. Most analysts have attributed this to a tightening of the credit markets in the United States caused by high levels of economic growth during the 1960s and high levels of government borrowing to fund government deficits (Gilber, 1986: 27-29; Lea, 1996; Barth, 2004). In 1966, Congress decided to make the interest rate ceilings proposed by Regulation Q binding. The rates were set to make commercial bank ceilings lower than savings and loan ceilings and thus to keep attracting deposits to the savings and loan banks. The rationale was that by setting rates, competi­tion between the banks for funds would lessen.

The worst was yet to come. Throughout the 1970s, inflation was high and eco­nomic growth was low. Interest rates were high, and as a result, the savings and loan banks were being pincered by the high cost of obtaining funds in the face of a declining and troubled housing market for new mortgages. When the Federal Reserve began to raise interest rates dramatically in the late 1970s, the business model of the savings and loans cratered. Not only was it difficult to raise funds because of Regulation Q, but mortgage rates rose dramatically and the market for new homes declined dramatically. The net worth of the entire industry ap­proached zero, falling from 5.3 percent of assets in 1980 to 0.5 percent in 1982 (Sherman, 2009). Not surprisingly, the savings and loan banks began to fail as a result of this pressure. By 1982, the number of saving and loans that were insol­vent rose dramatically (Brumbaugh et al., 1987). The FSLIC was ill equipped to deal with the prospect of widespread insolvency. According to some estimates, bailing out all the insolvent institutions in 1983 would have cost the FSLIC around $25 billion, but the fund held only $6.3 billion in reserves at the time.

This suggested that the industry was basically bankrupt. From the historical record, it is clear that neither the regulators nor Congress wanted to face the fact that the FSLIC could not bail out depositors. The savings and loan industry lobbied hard to give it another chance by changing the nature of regulation and allowing it to change its business model (Romer and Weingast, 1991). Two pieces of legislation were passed. President Carter signed into law the Depository Institutions Deregu­lation and Monetary Control Act (DIDMCA) of 1980.

The Garn-St. Germain Depository Institutions Act was passed by Congress in late 1982. This legislation had as its primary goal the partial deregulation of the savings and loan sector. It expanded the scope of activities permitted to thrift in­stitutions, and it broadened the type of assets that they could hold. It also relaxed regulatory accounting standards to allow thrifts to write down their low-interest mortgages and sell them without having to pay taxes.

The theory behind these two pieces of legislation was that they would buy the industry time to right themselves without having to resort to a costly bailout of depositors by the government. It would give the savings and loan banks time to shift their business models in order to meet the competition for deposits and allow them to make more risky investments to increase their profits. This theory has been described by policymakers and policy analysts after the debacle of the collapse of the industry as “massive gambling for resurrection” (see Calavita et al., 1997; Romer and Weingast, 1991). Of course, the banks were not gambling with their own money: their deposits were protected by insurance, and at the end of the day they knew the government would make sure depositors were bailed out.

Throughout the 1980s, Congress resisted efforts by regulators to intervene even after it became obvious that the newly deregulated savings and loan banks were not succeeding. This made the eventual bailout, when it came, even more expensive.

By the mid-1980s, it looked as if the prospects for the savings and loans were looking up as bank failures decreased from 252 in 1982 to 41 in 1984 (Brumbaugh et al., 1987). Between 1982 and 1985, deposits flowed in, and the savings and loan industry underwent a rapid expansion as Regulation Q was phased out and sav­ings and loan banks offered high interest rates for new deposits. Investors saw potential for profit in the new investment powers granted to thrifts and invested in condominiums and other commercial real estate. This meant that the invest­ment portfolios of savings and loan associations shifted away from traditional home mortgage loans into higher-risk loans. From 1981 to 1986, the percentage of savings and loan assets in home mortgage loans decreased from 78 percent to 56 percent. There was a great increase in investment in commercial real estate development and other risky investments such as junk bonds.

But much of this improvement was illusory. The ability of the savings and loan banks to hide their real financial conditions from regulators and to have the sup­port of the FHLBB and Congress protected them from oversight (Brumbaugh et al., 1987). In a deregulated industry with poor supervision, the competition for deposits spiraled out of control. Many institutions attracted capital by offering large brokered deposits at above-market rates. This meant that in order to justify these rates they had to make risky investments. Most of these investments failed to pay off. Also, in a deregulated industry where banks were playing with other people's money, fraud became rampant. By 1987, it became apparent that the in­dustry was in a disastrous financial situation (Tillman and Pontell, 1995).

There are two stories out there, both of which have some truth to them. The first story is that the terms of the deregulation created the crisis. Banks were given the ability to pay any interest rate that they wanted on deposits insured by the federal government up to $100,000. This meant that in order to attract capi­tal, they had to raise interest rates. To justify such high interest rates, they need­ed to make risky investments. This narrative emphasizes that the government failed to regulate the industry sufficiently to make sure that bank executives would not behave in a recklessly aggressive fashion. Some have viewed these executives as needlessly reckless, others as incompetent investors. The scholars who have this viewpoint argue that depository insurance and lax regulation caused the crisis (Barth and Bartholomew, 1992). The idea is that the govern­ment acted here as enablers to an industry filled with ex-alcoholics who could not resist a free drink.

One obvious problem with this story is that the lobbyists for the savings and loan industry put an enormous pressure on Congress to go along with the reforms that led to the ultimate demise of the industry. They kept that pressure on in the mid-1980s as things went from bad to worse. Given the members of Congress all had savings and loan banks in their districts, it is hard to imagine that they would have willingly pulled the plug. By blaming the government alone, critics forget that the industry lobbied long and hard to maintain their privileges. Using the language of addiction, the banks and the government were codependent, at the very least.

The second story is that the lax regulatory environment brought into the in­dustry players who had a different economic agenda: looting (Akerlof et al., 1993; Calavita et al., 1997; W Black, 2005a). The idea of looting is that executives cross over from engaging in risky investment behavior, which is not illegal even if it endangers the health of the firm, to behavior that is oriented to transfer money to the executives by engaging in transactions that show no possible prospect of profit (W.

There is evidence that in the wake of the deregulation of the industry, many of the savings and loan banks turned over their ownership to new management (Calavita et al., 1997). These managers saw the opportunity to rapidly expand the size of the bank by offering high-interest-rate deposits. But in this story, the main reason to expand the size of the bank was to feather the nest of the execu­tives who were in control. This brought these executives to engage in fraudulent lending in order to make the bank look more profitable than it was and to allow executives to pay themselves bonuses and use company funds to support lavish lifestyles. Calavita et al. (1997) document how these various schemes worked. Most of these fraudulent schemes took place in Texas and California, the epicen­ter of the eventual meltdown of the savings and loan banks. It has been estimated that between 11 and 44 percent of the losses in the crisis were due to fraud.

The collapse of the savings and loan industry brought the government into action once more. As hundreds of institutions failed, the FSLIC fund was over­run with claims. In 1987, the Government Accountability Office declared that the fund was insolvent by at least $3.8 billion. Congress responded with legislation that recapitalized the fund with $10.8 billion over the next year. However, trou­bled institutions continued to fail over that time, and more drastic action was re­quired. In 1989, President Bush signed into law a bailout plan for the savings and loan industry. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) abolished the FSLIC fund and transferred its assets to the FDIC. The FHLBB was abolished, and a new institution, the Office of Thrift Supervi­sion, was created to regulate savings and loans.

It was also in this piece of legislation that the Resolution Trust Corporation (RTC) was created to dissolve and merge troubled institutions. Between the FSLIC and the RTC, the federal government resolved the failure of 1,043 savings and loan institutions with total assets of $874 billion (in 2009 dollars). The total thrift industry declined from 3,234 to 1,645 institutions, a decrease of almost 50 percent. After all the dust had settled, the savings and loan crisis was estimated to cost taxpayers around $260 billion (W Black, 2005a). I remind the reader that if Congress and the Reagan administration had bit the bullet in 1983, the bailout would have cost around $25 billion.