Savings and Loan Crisis

The Savings and Loan crisis of the 1980/1990s was the failures of savings and loan association in the United States. Over 1,000 savings and loan institutions failed in "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time."^[1] The ultimate cost of the crisis is estimated to have totaled around USD$160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government ^[2], which contributed to the large budget deficits of the early 1990s. The resulting taxpayer bailout ended up being even larger than it would have been because moral hazard and adverse-selection incentives compounded the system’s losses. ^[3] A taxpayer funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans during the 2007 subprime mortgage financial crisis. ^[4] The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-1991 economic recession. Between 1986 and 1991, the number of new homes constructed dropped from 1.8 to 1 million, the lowest rate since World War II. ^[5]

Contents 1 The background 2 Causes 2.1 Deregulation 2.2 Inprudent real estate lending 2.3 Keeping insolvent S&Ls open 2.4 Brokered deposits 2.5 End of inflation 3 Failures 3.1 Home State Savings Bank of Cincinnati 3.2 Lincoln Savings and Loan 3.3 Herman K. Beebe 3.4 Silverado Savings and Loan 3.5 Resolution Trust Corporation 3.6 FDIC Banks 4 Cost 5 Impact 6 See also 7 External links 8 References 9 Notes

The background

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. In the United States, S&Ls were tightly regulated until the late 1970s. For example, there was a ceiling on the interest rates they could offer to depositors. In the 1970s, many banks, but particularly S&Ls, were experiencing a significant outflow of low-rate deposits, as interest rates were driven up by the high inflation rate of the late 1970s and as depositors moved their money to the new high-interest money-market funds. At the same time, the institutions had much of their money tied up in long-term mortgage loans that were written at fixed interest rates, and with market rates rising, were worth far less than face value. That is, in order to sell a 5% mortgage to pay requests from depositors for their funds in a market asking 10%, a savings and loan would have to discount their asking price on the mortgage. This meant that the value of these loans, which were the institution's assets, was less than the deposits used to make them and the savings and loan's net worth was being eroded. Under financial institution regulation which had its roots in the Depression era, federally chartered S&Ls were only allowed to make a narrowly limited range of loan types. Late in the administration of President Jimmy Carter caps were lifted on rates and the amounts insured per account to $100,000. In addition to raising the amounts covered by insurance the amount of the accounts that would be repaid was increased from 70% to 100%. Increasing FDIC coverage also permitted managers to take more risk to try to work their way out of insolvency so that the government would not have to take over an institution. When Jimmy Carter left office in January 1981, 3,300 out of 3,800 S&Ls lost money that year. In 1982 the combined tangible net capital of this industry was $4 billion. The chartering of federally-regulated S&Ls accelerated rapidly with the Garn - St Germain Depository Institutions Act of 1982, which was designed to make S&Ls more competitive and more solvent. S&Ls could now pay higher market rates for deposits, borrow money from the Federal Reserve, make commercial loans, and issue credit cards. They were also allowed to take an ownership position in the real estate and other projects to which they made loans and they began to rely on brokered funds to a considerable extent. This was a departure from their original mission of providing savings and mortgages.

Causes

Deregulation

Although the deregulation of S&Ls gave them many of the capabilities of banks, it did not bring them under the same regulations as banks. First, thrifts could choose to be under either a state or a federal charter. Immediately after deregulation of the federally chartered thrifts, the state-chartered thrifts rushed to become federally chartered, because of the advantages associated with a federal charter. In response, states (notably, California and Texas) changed their regulations so that they would be similar to the federal regulations. States changed their regulations because state regulators were paid by the thrifts they regulated, and they didn't want to lose that money.

Inprudent real estate lending

In an effort to take advantage of the real estate boom (outstanding US mortgage loans: 1950 $55bn; 1976 $700bn; 1980 $1.2tn)and high interest rates of the late 1970s and early 1980s, many S&Ls lent far more money than was prudent, and to risky ventures which many S&Ls were not qualified to assess. L. William Seidman, former chairman of both the FDIC and the Resolution Trust Corporation, stated: "The banking problems of the 80s and 90s came primarily, but not exclusively, from unsound real estate lending." ^[6]

Keeping insolvent S&Ls open

Whereas insolvent banks in the United States were typically detected and shut down quickly by bank regulators, Congress sought to change regulatory rules so S&Ls would not have some acknowledge insolvency and the FHLB would not have to close them down.

Brokered deposits

One of the most important contributors to the problem was deposit brokerage. Deposit brokers, somewhat like stockbrokers, are paid a commission by the customer to find the best certificate of deposit (CD) rates and place their customers' money in those CDs. These CDs, however, are usually short-term $100,000.00 CDs. Previously banks and thrifts could only have five percent of their deposits be brokered deposits; the race to the bottom caused this limit to be lifted. A small one-branch thrift could then attract a large number of deposits simply by offering the highest rate. In order to make money off this expensive money, it had to lend at even higher rates, meaning that it had to make more risky investments. This system was made even more damaging when certain deposit brokers instituted a scam known as "linked financing." In "linked financing" a deposit broker would approach a thrift and say that they would steer a large amount of deposits to that thrift if the thrift would loan certain people money (the people however were paid a fee to apply for the loans and told to give the loan proceeds to the deposit broker). This caused the thrifts to be tricked into taking on bad loans.^{[neutrality disputed]} Michael Milken of Drexel, Burnham and Lambert packaged brokered funds for several savings and loans on the condition that the institutions would invest in the junk bonds of his clients.

End of inflation

Another factor was the efforts of the federal government to wring inflation out of the economy, marked by Paul Volcker's speech of October 6, 1979, with a series of rises in short-term interest. This led to increases in the short-term cost of funding to be higher than the return on portfolios of mortgage loans, a large proportion of which may have been fixed rate mortgages (a problem that is known as an asset-liability mismatch). This effort failed and interest rates continued to skyrocket, placing even more pressure on S&Ls as the 1980s dawned and led to increased focus on high interest rate transactions. Zvi Bodie, professor of finance and economics at Boston University School of Management, writing in the St. Louis Federal Reserve Review wrote that "asset-liability mismatch was a principal cause of the Savings and Loan Crisis"[1]

Failures

The damage to S&L operations led Congress to act, passing a bill in [September 1981 ?] allowing S&Ls to sell their mortgage loans and use the cash generated to seek better returns; the losses created by the sales were to be amortized over the life of the loan and any losses could also be offset against taxes paid over the preceding ten years. This all made S&Ls eager to sell their loans. The buyers - major Wall Street firms - were quick to take advantage of the S&Ls lack of expertise, buying at 60-90% of value and then transforming the loans by bundling them as, effectively, government backed bonds (by virtue of Ginnie Mae, Freddie Mac, or Fannie Mae guarantees). S&Ls were one group buying these bonds, holding $150bn by 1986, and being charged substantial fees for the transactions. A large number of S&L customers' defaults and bankruptcies ensued, and the S&Ls that had overextended themselves were forced into insolvency proceedings themselves. The U.S. government agency Federal Savings and Loan Insurance Corporation (FSLIC), which at the time insured S&L accounts in the same way the Federal Deposit Insurance Corporation insures commercial bank accounts, then had to repay all the depositors whose money was lost. From 1986 to 1989, FSLIC closed or otherwise resolved 296 institutions with total assets of $125 billion. An even more traumatic period followed, with the creation of the Resolution Trust Corporation in 1989 and that agency’s resolution by mid-1995 of an additional 747 thrifts. ^[7] There were also state chartered S&Ls that failed. Some state insurance fund failed requiring state taxpayer bailouts.

Home State Savings Bank of Cincinnati

In March 1985, it came to public knowledge that the large Cincinnati, Ohio-based Home State Savings Bank was about to collapse. Ohio Gov. Richard F. Celeste declared a bank holiday in the state as Home State depositors lined up in a "run" on the bank's branches in order to withdraw their deposits. Celeste ordered the closure of all the state's S&Ls. Only those that were able to qualify for membership in the FDIC were allowed to reopen. ^[8] Claims by Ohio S&L depositors drained the state's deposit insurance funds. A similar event also took place in Maryland.

Lincoln Savings and Loan

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The most notorious figure in the S&L crisis was probably Charles Keating, who headed Lincoln Savings of Phoenix, Arizona. Keating was convicted of fraud, racketeering, and conspiracy in 1993, and spent 4 1/2 years in prison before his convictions were overturned. In a subsequent plea agreement, Keating admitted committing bankruptcy fraud by extracting $1 million from the parent corporation of Lincoln Savings, despite having the knowledge that the corporation would collapse within weeks. Keating's attempts to escape regulatory sanctions led to the Keating five political scandal, in which five U.S. senators were implicated in an influence-peddling scheme to assist Keating. Three of those senators - Alan Cranston, Don Riegle, and Dennis DeConcini - found their political careers cut short as a result. Two others - John Glenn and John McCain - were exonerated of all charges and escaped relatively unscathed.

Herman K. Beebe

Another character who was just as instrumental in the failure of S&Ls was Herman K. Beebe. He was a convicted felon and Mafia associate. He had many connections to the intelligence community and was considered godfather of the dirty Texas S&Ls. He initially started his career in the insurance business and eventually banking, specifically savings and loan banks. Houston Post reporter Pete Brewton linked Beebe to a dozen failed S&Ls. Altogether, Herman Beebe controlled, directly or indirectly, at least 55 banks and 29 S&Ls in eight states. What is particularly interesting about Beebe's participation in these banks and savings and loans is his unique background. Herman Beebe had served nine months in federal prison for bank fraud and had impeccable credentials as a financier for New Orleans-based organized crime figures, including Vincent and Carlos Marcello.

Silverado Savings and Loan

Silverado Savings and Loan collapsed in 1988, costing taxpayers $1.6 billion. Director of Silverado S&L, Neil Bush was accused of giving himself a loan from Silverado, he denied all wrongdoing. [2] Neil Bush is a son of President George H.W. Bush, who became president in 1989.

Resolution Trust Corporation

In 1989 Congress passed the Financial Institutions Reform Recovery and Enforcement Act of 1989 (FIRREA) and set up the Resolution Trust Corporation to liquidate assets of failed Savings and Loans. It spent $105.1 billion of US Government money to close 747 thrifts that had $394 billion of assets. ^[9]

FDIC Banks

While not part of the Savings and Loan Crisis many other banks failed. Between 1980 and 1994 more than 1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance. ^[10]

Cost

U.S. General Accounting Office estimated cost of the crisis to around USD $160.1 billion, about $124.6 billion of which was directly pay for by the U.S. government from 1986 to 1996. ^[11] It starts in 1986, when the FSLIC was reported insolvent and end on December 31, 1995, when RTC was required to cease its operations. It does not include thrift insurance funds before 1986 or after 1996. It does not include state run thrift insurance funds or state bailouts.

Impact

The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-1991 economic recession. Between 1986 and 1991, the number of new homes constructed dropped from 1.8 to 1 million, the lowest rate since World War II. ^[12] The market share of S&Ls for single family mortgage loans went from 53% in 1975 to 30 % in 1990. ^[13]

A taxpayer funded government bailout related to mortgages during the Savings and Loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans during the 2007 subprime mortgage financial crisis. ^[14]

See also

• Fractional-reserve banking
• Resolution Trust Corporation
• Tax Reform Act of 1986
• Cottage Savings Association v. Commissioner, a United States Supreme Court case dealing with the tax consequences of the S&L crisis

External links

• FDIC: The S&L Crisis: A Chrono-Bibliography
• The Cost of Savings & Loan Crisis: Truth & Consequences
• Classic Financial and Corporate Scandals

References

• Inside Job, by Steven Pizzo, Mary Fricker, and Paul Muolo. ISBN 0-07-050230-7
• "The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation," by Lawrence White(1991)
• "High Rollers: Inside the Savings and Loan Debacle" by Michael Lowy(1991)
• United States v. Winstar Corp., 518 U.S. 839(1996), a US Supreme Court case to be found on FindLaw.com that gives a concise but useful history of the crisis and the accounting practices that aggravated that crisis.
• "Legal Scholars Clash Over Neil Bush Actions" by Martin Tolchin. The New York Times, September 27, 1990.

Notes