David R. Evanson
Present Value: Essays on the Revolution & Evolutio, Winter, 2005
Few human endeavors are studied more meticulously than war. There are several reasons for this. First, most wars are fought by governments, and governments often keep detailed records. Information about every aspect of every battle — from the materiel used to supply logistics to the chain of command to the hearings that shaped public policy leading to the war in the first place — can be analyzed. Second, war is studied in detail because the stakes are so high: The fate of nations and the lives of their people hang in the balance of war’s outcome.
It’s with this in mind that we can look to France. Surely the devastation that the country suffered during World War I could provide a point of departure for study and analysis to make sure that it would not happen again. In fact, French military officers were diligent in their efforts following the First World War, arming themselves with all of the facts necessary to ensure that history wouldn’t repeat itself.
Curiously, their aggressor to the east studied the same facts. When the so-called long weekend was finally over, the two countries went to war armed with a shared history of what went right and what went wrong 25 years earlier. France, which thought itself impregnable, was overrun in just six weeks.
Thus we come to the connection to banking. While we can study the debacle of the savings and loan crisis in almost infinitesimal detail, the real question becomes this: Will we draw the right conclusions from what we learned? Or will we draw the wrong conclusions and, rather than avoid another crisis, actually take actions that put us on a collision course with it?
In studying the root causes of the S&L debacle, one remarkable fact stands out: how bad luck deepened the crisis and added to the staggering cost, which is estimated to be $175 billion. To understand just how bad the bad luck really was, in its nature as well as its timing, one must understand the public-policy blunders that preceded it.
A more philosophical analysis might suggest that the policy blunders provoked the bad luck that followed. Surely, with a different set of policies in place, the effects of declining oil prices and the fallout in the real estate sector of the economy might not have been magnified to the degree they were. While there is a multiplier effect as a result of making loans, the same phenomenon seemed to occur with the S&L crisis, but in reverse: Wealth seemed to shrink in excess of the actual loss incurred.
Some of the seeds of the S&L disaster were sown long before the crisis ever materialized. Looking at these factors in total, it was almost as if disaster was imprinted on the very genes of S&Ls. All that was required was enough time for germination.
The first of these seeds was the advent of deposit insurance, which materialized during the Depression and was extended to savings and loan institutions in 1934. Absent any other economic and policy changes, deposit insurance was destined to ultimately leave taxpayers with a large bill because it was conceptually unsound. Specifically, federal deposit insurance was not priced for risk. Each savings and loan institution in the system paid the same premium for insurance regardless of how much risk they may have posed, resulting in an approach that no private insurer in the world utilizes.
As an extreme example, consider how hard money lenders — opportunistic individuals and institutions that make loans no federally insured institution would touch — protect themselves. They price for risk. Under their model, all loans are viable. Those that don’t get done are the ones in which the borrower is unable or unwilling to pay the kind of fees and interest that their risk justifies.
Under the model of federal deposit insurance, there was no incentive for a lender to exercise prudence, because prudence had no impact on the cost of insuring loans and, in fact, it put the lender at a competitive disadvantage. This is not to suggest that the presence of deposit insurance in and of itself created a moral hazard, but during the mid-1980s, the confluence of several events would encourage, and perhaps even necessitate, risktaking by S&Ls. The underlying insurance premiums offered no restraint. Moreover, the presence of a third-party guarantee in the form of deposit insurance also obviated the imposition of restraint by depositors or shareholders.
Another structural flaw built into the savings and loan industry long before the crisis ever materialized was federally mandated maturity mismatching. Of course, that wasn’t the official name. It was called the federal government’s effort to promote home ownership. The resulting maturity mismatches were simply an expensive and unfortunate byproduct of the policy.
Political scholars have long debated whether fiscal policy should be used solely to manage and promote economic growth, or if it should also act as an instrument of social policy. While this debate can probably never be extinguished, proponents of the former camp have compelling new evidence for their point of view.
When policymakers finished their work in 1934, the interest rates on federally insured deposits were higher than passbook savings accounts but less than the prevailing rates for mortgages. Thus, public policy gave consumers an incentive to make deposits in S&Ls and focused these institutions primarily on the business of making mortgage loans. The savings and loan industry had what no other private enterprise had: a guaranteed operating profit and little competition.
As an aside, it’s noteworthy to consider that this arrangement did not attract dynamic managers. This wasn’t an issue when profit was regulated and assured. But it became a significant and material issue when the industry was deregulated, in many cases forcing institutions to enter into businesses that the management team was not qualified to administer.
Unfortunately, the regulatory cocoon in which thrifts lived assumed a stable interest-rate environment. In fact, a stable interest-rate environment is the only scenario under which short-term liquid deposits could fund long-term illiquid mortgages. As Fig #XXX indicates, prior to 1972, policymakers had some evidence to believe that a stable interest-rate environment would prevail.
Right: Prime Interest Rate
Left: Borrowing rate
Unfortunately, by the late 1970s, there were some very serious challenges to this assumption. The forces that drove interest rates upward were manifold and merit further discussion later in this chapter. However, regarding maturity mismatching, the effects of rising interest rates were almost immediate. When rates spiked and reached their zenith in 1982, the savings and loan industry had a negative net worth of $100 billion, when its mortgages were valued on a mark-to-market basis. Adding fuel to the fire was a federal ban on adjustable-rate mortgages, which exacerbated the mismatch from the asset side of the balance sheet. Clearly, the maturity mismatching that was set in motion 50 years earlier had come home to roost with disastrous consequences.
Another noteworthy structural flaw was the presence of Regulation Q. This 1933 law enabled the Federal Reserve to limit the interest rates that banks could pay on their deposits. In 1966, Regulation Q was extended to savings and loan institutions.
There are so few instances of price controls actually delivering the intended benefits that the real wonder is not that Regulation Q caused problems, but rather why it was extended to savings and loan interest at all.
Like almost all price controls, Regulation Q held the line on a visible cost, but introduced a new and perverse and less-visible cost. As an example of how price controls distort pricing, consider the price controls on gasoline first in 1973 and then again in 1979. When service stations sold gas on a first-come, first-served basis with the maximum prices determined by the federal government, long lines materialized. These long lines were the perverse cost. Even though consumers saved money on each gallon they bought at controlled prices, they gave it all back — and then some — when the value of their time spent standing in line was taken into account. Imagine the cost per gallon for an attorney charging the then unheard of rate of $250 per hour.
Regulation Q was no different. Putting a ceiling on the interest that savings and loans could offer consumers — which in turn enabled them to earn an apparent profit with relatively inexpensive fixed-rate mortgages — simply meant that savers were subsidizing homebuyers. Like the First Law of Thermodynamics, which says that energy can be neither created nor destroyed, financial dynamics would suggest that no cost can ever be eliminated; instead, it is passed to another segment of the economy.
With respect to Regulation Q, not all of the cost was passed from homebuyer to saver. One of the net effects of the cross subsidy was that it perpetuated the maturity mismatching for several years and, as a result, deepened the cost of the bailout. Thus, while savers bore some of the cost in the form of foregone interest income, the taxpayer bore the rest. Sadly, some consumers got hit with the cost twice — as savers and taxpayers.
While these inherent and longstanding structural flaws exerted their slow and corrosive effects, fiscal and monetary policies of the 1980s -– many of which were designed as corrective measures –- added more fuel to the fire. It’s easy to draw this conclusion with hindsight. Foresight, especially during the middle of the crisis, was much harder to come by.
For example, the deregulation of the savings and loan business seemed like a good idea at the time. The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) enacted in 1980 and the Garn-St. Germain Depository Institutions Act of 1982 represent the cornerstone legislative efforts to deregulate the industry.
The DIDMCA was a Carter-era initiative that gave S&Ls the ability to make so-called ADC (acquisition, development and construction) loans, initiated the removal of the interest ceiling on deposit accounts, and raised the deposit insurance limit from $40,000 to $100,000.
The Garn-St. Germain Act, a Reagan-era initiative that completed the removal of the interest-rate ceiling, eliminated the prior statutory limits on loan-to-value ratios and expanded the range of loans that S&Ls could make. Specifically, post-Garn-St. Germain, savings and loans could have up to 40 percent of their assets in commercial mortgages, 30 percent in consumer loans, 10 percent in commercial loans, and 10 percent in commercial leases. For management teams that were used to collecting deposits with regulated rates and making residential mortgage loans, this was new territory indeed.
Parenthetically, there’s controversy as to whether or not the crisis was deepened when the limit on deposit insurance was raised. Proponents of the view that the Garn-St. Germain Act did not add to the crisis pointed out that an investor who wanted to get $120,000 earning 10 percent on an insured basis had only to break his deposits into chunks and find three savings and loans willing to accept the funds.
Critics of the act suggest that raising the ceiling by 150 percent attracted so-called brokered deposits. These deposits, which came to be known as “hot money,” were funds aggregated from brokerage firms and other sources and broken up to fit into insured accounts at savings and loans. The infusion of billions of new capital that would ultimately be lost by savings and loans may not have provoked the crises but undoubtedly increased the price tag. Moreover, since hot money from the brokerage firms chased the highest rates, the $100,000 limit provided liquidity to the weakest institutions and perhaps hid the true magnitude of the problem from regulators for longer than it would have been hidden otherwise.
Still, at the time deregulation seemed like a good idea. The underlying thinking was that if thrifts could enter higher-margin businesses and earn more profits, they could grow themselves out of the difficult position they had been regulated into.
Much of this was predicated on the belief that the Federal Home Loan Bank Board (FHLBB) was up to the task of overseeing an industry not only in crisis, but now in transition. Unfortunately, according to the FDIC’s chronology of the savings and loan crisis, between 1982 and 1985 the FHLBB actually reduced its supervisory and regulatory staff. The remaining personnel were not only stretched thin, but they were also inexperienced and poorly paid. In 1983, a starting savings and loan examiner was paid $14,000 and had just two years of experience. In addition, while the regulatory staff was shrinking, deregulation was taking hold and institutions were growing. According to the FDIC, industry assets increased by 56 percent between 1982 and 1985. In Texas, 40 S&Ls tripled in size between 1982 and 1986. Savings and loan institutions in California followed a similar pattern.
As history has shown, this was not healthy growth. In fact, it was cancerous growth, because standards were undermined during the process of deregulation and because of how saving and loan institutions accounted for their growth.
For instance, in 1981, the Federal Home Loan Bank Board permitted the use of so-called regulatory accounting principals, known as RAP, which were much less vigorous than the GAAP standards to which they were traditionally held. In a direct contradiction to the GAAP principal of recognizing a loss when it’s likely but a gain when it’s realized, under RAP savings and loans were permitted to defer losses on the sales of assets with below-market yields.
On the capital side, the deteriorations were more egregious. In 1980, the Federal Home Loan Bank Board reduced the net-worth-to-deposits ratio from 5 percent to 4 percent and then reduced it again in 1982 from 4 percent to 3 percent. Further, the Federal Savings and Loan Insurance Corporation issued net-worth certificates to savings and loans; these certificates were really nothing more than IOUs from what would ultimately become an insolvent insurance fund. Worse, however, these net-worth certificates could be counted as capital.
Also questionable was the accounting treatment of losses from acquired thrifts. If one savings institution acquired another, the buyer could add the difference between the acquired company’s assets and liabilities as goodwill, and the goodwill was then counted as capital. Such treatment was particularly perverse because it took a loss and converted into something it should and could never really be: capital.
But if luck is where opportunity and preparation intersect, then bad luck is where mistakes and misfortune cross. With respect to the savings and loan crisis, the mistakes were the public-policy initiatives mentioned above; the misfortune was high inflation, precipitous decline in oil prices, and a falloff in the real estate sector.
At first, it seemed as if a booming oil economy were a blessing. The expanded lending powers of savings and loans were met with a capital-hungry oil and real estate sector. While this worked miracles as oil prices rose, it had a disastrous effect when oil prices fell.
TEXT FOR SIDE OF CHART Price per barrel
With oil prices in a precipitous decline from 1982 through 1986, thrifts whose loan portfolios were dependent not just on oil prices but on high oil prices accumulated billions in losses. The length of the decline, coupled with its severity, caused what amounted to a depression in the oil and real estate economies, creating declines in regional employment. The downward pressure on savings and loans was unbearable. Management teams not yet seasoned in commercial lending faced defaults on their business loans; they also faced rising delinquencies and defaults on home mortgages and consumer loans that were dependent on employment driven by a once-booming oil economy. At savings and loans exposed to these dynamics, insolvencies became widespread.
There was more bad luck. Starting in 1976, inflation reared its ugly head once again. Then Federal Reserve Board Chairman Paul Volcker decided to attack the problem through monetary policy. The Fed’s resulting restriction of the money supply drove interest rates up. From June 1979 to March 1980, short-term interest rates rose by more than 6 percentage points.
TEXT ON LEFT SIDE: Percentage
New Title: U.S. Inflation Rates 1960 to 1983
Source: Federal Reserve Bank of Minneapolis
For the economy at large, this tough-love approach might have made sense, but for savings and loans it didn’t. They had long-term fixed-rate loans on their books, and they were put in the position of paying more for their deposits than they could ever hope to make on their mortgages. By 1981, the interest-rate spreads for savings and loans were a negative 1 percent. As mentioned earlier, when their mortgages were valued on a mark-to-market basis, the savings and loan industry had a negative net worth of $100 billion.
And then there was even more bad luck. The Tax Reform Act of 1986, which like the Fed’s restrictive monetary policy may have been good for the economy at large, was nonetheless ill-timed for an industry in crisis. Some economists have suggested that the Tax Reform Act of 1986 was the most sweeping reform of the federal tax system since the federal income tax was introduced in 1913. One of the primary goals of this Reagan-era legislation was to create a fairer system that slashed rates and eliminated targeted tax breaks.
Parenthetically, it’s worth noting that many targeted tax breaks have worked their way back into the tax code since 1986. However, one of the most cherished of these tax breaks that was eliminated, and which has not come back, was the deductibility of passive losses from real estate investments. Following the enactment of the Tax Reform Act of 1986, real estate projects that were viable because they produced passive losses — and hence sheltered income — were no longer viable under the new tax regime. This put yet more pressure on a struggling real estate sector and delivered additional defaults to savings and loan institutions.
Finally, bad luck and bad policies were exacerbated by congressional inaction and a lack of candor from the Federal Home Loan Bank Board. Several intrinsic truths about political organizations applied equally, if not exponentially, to these two bodies and their relationship to thrifts. These truths ultimately deepened the fallout of the savings and loan crisis. First, despite what their charters might say about whom the real constituents are, a political organization’s first priority is the preservation of itself, and almost all of its activities will reflect this objective. Second, because of this orientation, political organizations will be slow to recognize serious issues that call into question their supervision. Third, a crisis is the only force powerful enough to overcome truths one and two.
This helps to explain why, rather than confronting the problems that faced savings and loan institutions, the Federal Home Loan Bank Board devised a number of accounting treatments to create the appearance of solvency in their industry. It also helps to explain why it took until 1987 -– fully six years after the regulatory accounting principals (RAP) were put into place by the Federal Home Loan Bank Board — for the Competitive Equality Banking Act to be enacted, which required the FHLBB to develop accounting standards that followed GAAP. Once enacted, the 1987 law took two years to become effective and another five years to achieve total accounting uniformity.
Finally, these intrinsic truths help explain why it took until 1989 for Congress to take decisive action in the form of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, or FIRREA. The act was sweeping and largely effective, but it took overall weakness in the industry, widespread insolvency and more than $50 billion in thrift losses to generate the political momentum required to get it enacted.
The 1960s were a time of great prosperity for thrifts. They were fulfilling their mandate of promoting home ownership. A stable interest-rate environment, coupled with mortgage demand, meant stable profits and, for management of savings and loans, a period of optimism and equanimity. But this period prior to the great savings and loan debacle demonstrates a central truth in banking: The seeds of future problems are sown when things are going well.
Thus, the prosperity that banks enjoy today raises a question. From which direction will the next crisis come? There’s one possible candidate: electronic banking.
Drawing once again on the analogy that opened this chapter, will we repeat the error of France prior to World War II? When France declared its eastern frontier impregnable, it looked at the wrong set of facts. It drew upon the experience of the First World War, with its mechanized and marching armies, and built defenses to repel a similar assault. What France should have taken into account was the growing threat posed by air power. While bank regulation focuses on capital standards, compliance and risk concentrations, perhaps the next great challenge for banking will come from a completely different direction altogether.