The savings and loan crisis of the 1980s and 1990s created the greatest banking collapse since the Great Depression of 1929. Savings and Loans were specialized banks that used low-interest, but federally-insured, deposits in savings accounts to fund mainly residential mortgages. By 1989, over half of the Savings and Loans had failed, along with the deposit insurance fund (the FSLIC) that was created to insure their deposits. The crisis cost more than 150 billion US Dollar, with taxpayers footing the bill for at least 124 billion US Dollar. A boom and bust cycle in housing came along with the Savings and Loan Crisis but it was no (decisive) cause for the emergence of the crisis.
Causes for the Savings and Loan Crisis
Most analysts today agree that the savings and loan crisis can be mainly traced back to failures in financial industry regulation and bank risk management practice. It is therefore not a big surprise that several causes have their roots before 1980.
From the early 1960s there were growing worries that the S&L industry was not competing effectively for funds with commercial banks and securities markets, leading to large swings in the amount of money available for mortgage lending. The worries were justified as, first, the savings and loans lacked diversification (their business activity was usually restricted to a certain region and concentrated almost solely in residential financing) and, second, faced a material maturity mismatch (by accepting deposits that could be withdrawn quickly and making 20-year loans). Therefore, the government passed Regulation Q which put a ceiling on the interest rate banks could offer to depositors, allowing savings and loans to pay a bit more for savings deposits than commercial banks were allowed to. This system was eroded by the high inflation period in the 1970s when (new) money market funds began to compete fiercely for depositors’ money by offering interest rates set by the market. In effect, savings and loans suffered from a significant withdrawal of deposits and several were in the red. The problem got worse after deposit interest rate ceilings were eliminated between 1980 and 1982 and savings and loans started to offer interest rates in line with or even above market rates. Consequently, an unsustainable gap opened up between the cost of their funding liabilities (short-term interest rates) and the income generated by their assets (long-term, fixed-rate mortgage repayments). However, regulators in the early 1980s apparently lacked the political, financial or human resources to close large numbers of institutions. Instead, between 1980 and 1982, the government offered “regulatory forbearance” to postpone the threatened insolvency of the sector in the hope that interest rates would quieten down and S&Ls would finally be able to “grow” out of their problems. The changes in regulation allowed the savings and loans to shift their focus towards assets that were more immediately lucrative (and risky) than residential mortgages; at the same time, capital standards were debased as well. The legislative moves of the early 1980s also included the raising of the level of insured deposits from 40,000 US Dollar to 100,000 US Dollar so that even badly damaged institutions could attract funds by paying interest rates marginally above the market rate as savers knew their deposits were insured by government guarantees. The relaxed rules enabled the savings and loans to grow fast and most of them seized the chance, so that the asste base of the thrift industry was expanding by leaps and bounds.
The changes in regulation offered the savings and loans also the chance to take advantage of the real estate boom and to fuel it further. The credit and investment risk of savings and loans rose while, at the same time, their capital base eroded and their risk management was insufficient. Besides, corruption also played its part in order to set the scene for reckless decision making, misvaluation and deliberately obscure financial reporting and documentation. While the original cause for the crisis was eased by a more favourable interest rate environment, the accumulated losses due to asset quality problems grew even more. From the mid 1980s a series of US regional crisis acted to realise the risk embedded in savings and loans portfolios. Yet, public awareness of the enormous scale of the savings and loans crisis continued to be relatively muted until 1989 when Congress passed several laws, substantially restructuring US financial industry regulation. The insolvent FSLIC was abolished and new institutions founded which equipped regulators with new funding and power, enabling them to act aggressively to close down institutions. From 1993 to 1995 the industry began to stabilise.
Consequences and Lessons Learned
In general, the savings and loan crisis has shown that mistaken monetary policy and an insufficient and improper regulatory system can cause a systemic crisis. The crisis has illustrated, in particular, that regulatory capital and accounting numbers are not necessarily a good guide to risk-adjusted profitability in the banking industry and that poorly controlled lending institutions might disguise their true level of risk and return. The consequences of the crisis for the structure and regulation of the US financial industry were profound and regulation considerably improved. In spite of these efforts, more should have been learned from this crisis.
The system of US housing finance underwent a fundamental restructuring following the savings and Loan crisis. Mortgage lending changed from being dominated by local and regional balance-sheet lending by depositories, to a national, (capital) market-based system of securitised mortgage finance.