An Analysis of the Savings and Loan Crisis of the 1980s: Inflation, Deregulation and Recession

1. An Analysis of the Savings and Loan Crisis of the 1980s: Inflation, Deregulation and Recession Adam D. Zubritsky ECO 6226 Seminar in Money and Banking Summer, 2004

2. Topic This paper focuses on the Savings and Loan industry crisis in the 1980s. A history of savings and loans, characteristics of the industry and macroeconomic events that led to the crisis, and the overall impact on domestic GDP are analyzed. The savings and loan crisis required a government bailout in 1989 since deposit insurance went bankrupt long before compensating depositors in over 1500 failed savings institutions. According to a report from the FDIC, the total cost of the S&L crisis in the American economy was over $160 billion, with over $132 billion coming from taxpayers.

3. This topic is important because it relates to other crises in the financial industry that required federal action. There are many lessons to be learned from the S&L crisis including the importance of controlling domestic inflation and interest rates, designing deposit insurance to minimize moral hazard, and adequate regulation to prevent such crises.

4. Definition: Saving and Loan Associations (thrift institutions) are deposit-taking institutions initially created for the purpose of taking in deposits from private citizens and using them to make home mortgage loans. Function: Intermediation function begins with taking in deposits and paying interest. A higher return must come from the lending in the form of home mortgages. This function works best when interest rates are low and stable.

5. Provisions: S&Ls offer savings accounts which earn interest, CDs, and Negotiable Order of Withdrawal (NOW) accounts, which are similar to checking accounts. Assets mainly consist of mortgages, the remaining portion in consumer loans and government securities. EarlyLegislation: Began as mutual-type or stock-type, state-chartered only.Home Owner’s Loan Act of 1933 allowed S&Ls to have either federal or state charters. Oversight/regulation at the federal level from Federal Home Loan Bank Board (FHLBB).

6. Glass-Steagall Act of 1933/Regulation Q imposed interest rate ceilings on deposits, but none on lending. National Housing Act of 1934 established the Federal Savings and Loan Insurance Corporation (FSLIC) – the insurer of deposits in S&Ls

7. Timeline 1950s-1960s: Generally stable interest rates and focus on long-term home mortgage lending leads to successful operation and growth of S&Ls. 1970s: High inflation in the U.S. causes nominal interest rates to skyrocket. Deposit funds begin to flow out of S&Ls and into higher-earning investments such as mutual funds. S&L deposit rate ceilings set by Regulation Q are still in place. Late 1970s: S&L industry starts showing first signs of buckling and becoming insolvent.

8. 1980: Depository Institutions Deregulation and Monetary Control Act (DIDMCA) Began phasing out interest rate ceilings on deposits, increased allowance for commercial and construction lending by S&Ls. These assets had higher returns than traditional mortgages, but came with greater risk. Deposit insurance was increased to $100,000 per account without subsequent increase in insurance premiums, and the moral hazard and adverse selection problems worsen. Commercial deposits allowed in S&Ls. Credit cards issued by S&Ls as another high-interest-earning (but risky) asset.

9. 1981-1982: Recession hits the U.S. economy. Brakes put on high inflation. Major increases in S&L failures, but regulators grant forebearance to institutions that may recover after interest rates fall and avoid paying out deposit insurance. 1982: Garn-St. Germain Act allowed S&Ls to offer money market deposit accounts that paid market interest rates. Allowed even greater percentage of commercial loans as assets. The FDIC and FSLIC could now merge institutions across state lines. This was part of a merger wave designed to avoid having to close institutions and pay out deposit insurance.

10. Mid-1980s: In order to compete for funds, S&Ls must pay higher rates to depositors. However, due to the long-term fixed-rate mortgages, the S&Ls are lending money at a lower rate than they are paying to borrow. Institutions also engage in high-risk lending and are carrying very little capital in relation to total assets. This leads to more insolvencies among S&Ls, and also more forebearance to avoid insurance payouts. 1987: The FSLIC, which was undercapitalized, goes bankrupt. The CEBA was created to recapitalize the FSLIC, but this failed.

11. 1989: Federal Institutions Reform, Recovery, and Enforcement Act (FIRREA) finally eliminated the FHLBB and bankrupt FSLIC. The FHLBB was replaced with Office of Thrift Supervision (OTS) and savings and loans became insured by the FDIC under the Savings Association Insurance Fund (SAIF). Initially, they paid higher rates for insurance than banks. S&Ls could convert their charter to become savings banks and pay lower deposit insurance premiums. Required that S&Ls invest a larger share in mortgages along with new asset and capital requirements. Supervisors could intervene sooner in cases where an institution showed warning signs of becoming insolvent.

12. 1989 saw the highest number of S&L failures, many being closed by the government. The bailout costs were high, and out of this also came unemployment. The government had to bail out the bankrupt FSLIC and ensure all depositors received their deposits. 1990-91: Recession hits the U.S. economy. Data show that there is a likely connection between failures of savings institutions and drops in GDP. However, standard capital/asset ratios and capital/deposit ratios, the commonly-accepted indicators of financial solvency, do not accurately reflect the trend in failures.

13. Today’s S&L industry is much different. Although both S&Ls and banks still exist, differences between them have diminished. Banks now provide mortgage lending, consumer loans, and commercial loans. Banks have also engaged in many other types of financial business. All deposits are insured by FDIC and both banks and thrifts fall under the Deposit Insurance Fund. This eliminated BIF and SAIF and equalized insurance rates for all types of institutions.

14. Other Literature on the S&L Crisis Papers and books regarding the savings and loan crisis are overwhelming. This was a major topic of discussion among academic economists and Federal Reserve researchers in the late 1980s and early 1990s. The major force was on identifying the causes of the crisis, what was done wrong, and how to prevent future collapses in the financial industry. The overall impact on the U.S. economy was not completely described in prior analyses.

15. George Kaufman and Steven Seelig at Loyola University discuss the costs of the crisis. They conclude that in dollar terms only 3% of the variance of GDP in the 1980s was caused by fluctuations in the S&L industry. They do not offer statistical analysis to back up their claim. • The FDIC collects data on bank and thrift failures. They cite a connection between low capital/asset ratios and S&L failures between 1980 and 1988. They also state the cost of the entire crisis in dollar terms. • Arturo Estrella et. al. at the Federal Reserve Bank of New York discuss capitalization ratios as predictors of deposit institution failures. They find that risk-based ratios are no better at predicting failures than standard ratios, but it is hard to obtain aggregate measures relating to the default risk of assets held by institutions.

16. Christopher Neely of the St. Louis Federal Reserve and Elijah Brewer and Douglas Evanoff of the Chicago Fed present papers discussing the role of deposit insurance, moral hazard creation, and financial crises that require government bailouts. Neely compares the S&L crisis and subsequent insurance bailout to the events following September 11, 2001. • R. Alton Gilbert of the St. Louis Fed wrote 2 papers. The first presents an argument for risk-based capitalization ratios and risk-based deposit insurance premiums to alleviate the moral hazard problem. The second paper presents an argument for shutting down undercapitalized S&Ls and the need for stronger government supervision to minimize crises. • David C. Wheelock and Philip Dybvig of the St. Louis Fed also discuss the role of deposit insurance, moral hazard, and regulations.

17. Analysis of Paper Data show that S&L failures precede both recessions. There is likely causality of as much as 23% of the variation in GDP. While FSLIC went bankrupt, the government eventually depositors their lost amounts, preventing widespread bank panic. This was a transfer of capital. However, time delay between failure and payout, lost faith in financial institutions, high government bailout costs that could have been used for other purchases, and unemployment caused by the closing of over 1500 institutions led to economic downfall.

18. Annual Data on S&L Failures

19. Estimated Regression: lnYt* = β1 + β2(lnFAILt*) + β3(lnFAILt-1*) + β4(lnFAILt+1*) + ε note: lnYt represents detrended real GDP. * All data is adjusted for serial correlation using the quasi- first differencing procedure. Variable Description Mean OLS Constant -0.00007 (-.016) lnFAILt S&L failures coincident 1.1045 -0.01047 (-1.792) lnFAILt-1 S&L failures lag 1.1045 -0.0001587 (-.038) lnFAILt+1 S&L failures lead 1.0003 0.012326 (2.3730) n = 23 R2 = .2296 DW = 1.5341 p = .23293

20. Real GDP and S&L Failures

21. Similar analyses were run to determine the effectiveness of standard capital/assets and capital/deposits ratios in predicting S&L failures. The results show that these ratios are poor indicators of S&L failures. A possible reason for the lack of correlation could be that forebearance actually tended to reduce the number of failures despite the low amount of capital held in so many institutions. Forebearance was only granted when capital/asset ratios were generally low. Institutions that were allowed to remain open and survived into the early 1990s enjoyed low interest rates. This and tighter regulations made failures extremely rare after 1993.

22. What Have We Learned from the S&L Crisis and this Analysis? • We have learned the damaging effects of high inflation and interest rates on financial intermediaries, an obvious argument for controlling domestic inflation. • We have learned the negative effects of quick deregulation and lack of oversight as well as the moral-hazard and adverse-selection problems caused by deposit insurance. Also, the lack of depositor oversight caused by insurance cannot be ignored either. Deposit insurance should be established so that it minimizes these problems and yet provides the stability and protection needed by small depositors.

23. This analysis has presented evidence that S&L failures were a leading cause of the recessions of the early 1980s and early 1990s. The failed institutions may have had as much as a 23% effect on GDP. This is much greater than previously believed. The recessions partially caused by the S&L crisis were from deadweight losses, slow payouts to depositors, and unemployment. Also there was a general loss of faith in deposit institutions. • We have learned from this analysis that standard capitalization ratios in general do not go far in determining savings and loan failures. Risk-based ratios may be more reliable indicators, but we do not have adequate data at this point for a comprehensive analysis on this, especially since risk assessments were not required during the period of the savings and loan crisis.

24. Questions… Comments… Concerns… Have a great evening!