The 1980s US Savings and Loan Crisis 50 comments

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In the midst of a (temporary?) respite from the subprime crisis that enveloped global financial markets in panic over the last two weeks, I find it an appropriate time to look back at a similar crisis that the subprime issue is often compared to: the US savings and loan crisis of the 1980s. There are indeed some parallels that can be drawn between the two.

In the US, savings and loan institutions (also known as S&Ls or thrifts) have existed since the 1800s. They originally served as community-based institutions for savings and mortgages for the conservative residential mortgage sector, surrounded by legislation put in place in the 1930s to promote home ownership. Hardly a likely candidate to cause what became known as the biggest financial scandal in the US.

But things change. Between 1960 and 1980 that environment changed out of recognition. Particularly in the 1970s, the interest rate market became increasingly volatile as inflation soared. Mandated to offer a low interest rate that they could offer to depositors, the S&L industry lost its competitiveness for funds with commercial banks and securities markets, leading to lesser amounts of money available for mortgage lending.

Deregulation in the early 1980s removed the abovementioned deposit interest rate ceilings, increasing the competitiveness of S&Ls in sourcing for depositor funds. A new problem was brewing: by raising their cost of funding, margin pressure was created on the income generated by their mortgage loans. What was worse, the liabilities (deposits) were short-term, while the assets (mortgage loans) were long-term, typically fixed-rate interest --- a so-called asset-liability mismatch.

Between 1980 and 1982, regulators, industry lobbyists and legislators put together various legislative and regulatory mechanisms to postpone the threatened insolvency of the sector in the hope that interest rates would quieten down and S&Ls would be able to engineer themselves back into profitability. The approach was to loosen S&L capital restrictions, while offering S&Ls new freedom to extend their activities into potentially lucrative (and therefore risky) areas --- which planted the seeds for the next crisis.

S&Ls were allowed to sell their mortgage loans and use the cash generated to seek better returns. In particular, S&Ls began to both lend to real estate developers and to invest in real estate, construction and service companies. In key regions, such as Texas and Florida, S&L lenders competed with other lenders such as commercial bankers to fuel a real-estate boom. And yet, the traditional risk management skills of mortgage lenders, where credit risk is relatively low and predictable, and property and collateral prices relatively stable, did not equip most S&Ls to venture into the strongly cyclical commercial real estate market. A mismanagement of investment risk, driven by greed for high yields, characterise both the S&L crisis and the current sub-prime crisis.

The mid to late 1980s saw the long-term impact of such risk mismanagement. A series of US regional crises, triggered by collapses in the oil, property and farming sectors, acted to realise the credit and investment risks now embedded in S&L portfolios. For example, the oil-price inspired boom of the early 1980s in Texas was faltering, and by 1987 its oil and real estate sectors were in deep recession. A similar process of increasing rates of default and falling collateral values remorselessly undermined S&L asset around the US, right through until 1992.

Realising the threat of insolvency facing many S&Ls, from 1986 onwards, politicians and regulators struggled with a series of measures to fund the restructuring of the industry, but these failed to match up to the scale of the problem. Much of the restructuring was accomplished through encouraging mergers and acquisitions between S&Ls. Public awareness of the enormous scale of the S&L crisis continued to be relatively muted into the late 1980s, surprisingly, until 1989 when a new Act was passed that substantially restructured US financial industry regulation and belatedly recognised that US taxpayers would end up paying much of the bill for the S&L fiasco.

Regulators began to act aggressively to close down S&L institutions, though it quickly became clear that the situation in the S&L industry was even worse than had been imagined. In 1989 and 1990 the S&L crisis reached its height in terms of public expense, with total bailout expense (taxpayers' money) estimated in the hundreds of billions. It contributed to the large budget deficits of the early 1990s, and the resulting slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-1991 economic recession.

The episode is a prime example of the dangers of deregulation, especially for financial institutions. With the withdrawal of regulatory oversight coupled with mismanagement, there is great potential for excessive risk-taking. It also illustrates how formalistic reporting of the financial condition of S&Ls was deliberately selected by interested parties to cover up the true economic extent of the unfolding disaster, truly a risk-reporting failure on a grand scale.

References:
(1) US Savings and Loan Crisis
(2) Wikipedia: Savings and Loan crisis